RETURN ON EQUITY AND DUPONT’S ANALYSIS

# RETURN ON EQUITY AND DUPONT’S ANALYSIS

#### DuPont’s Analysis

DuPont’s Analysis is an extended examination of the Return on Equity (ROE) of a company that analyses Net Profit Margin, Asset Turnover, and Financial Leverage. This analysis was developed by the DuPont Corporation in the year 1920.

In simple words, it breaks down the ROE to analyze how corporate can increase the return for their shareholders.
Return on Equity = Net Profit Margin * Asset Turnover Ratio * Financial Leverage = (Net
Income / Sales) * (Sales / Total Assets) * (Total Assets / Total Equity)
The company can increase its Return on Equity if it-

• Generates a high Net Profit Margin.
• Effectively uses its assets to generate more sales
• Has a high Financial Leverage

#### Components of DuPont’s Analysis

This analysis has 3 components to consider;

1.Profit Margin– This is a very basic profitability ratio. Calculated by dividing the net profit by total revenues. This resembles the profit generated after deducting all the expenses. The primary factor remains to maintain healthy profit margins and derive ways to keep growing it by reducing expenses, increasing prices, etc, which impacts ROE.

2.Total Asset Turnover– This ratio depicts the efficiency of the company is using its assets. Calculated by dividing revenues by average assets. This ratio differs across industries but is useful in comparing firms in the same industry. If the company’s asset turnover increases, this positively impacts the ROE of the company.

3.Financial Leverage– This refers to the debt used to finance the assets. The companies should strike a balance in the usage of debt. The debt should be use to finance the operations and growth of the company. However, usage of excess leverage to push up the ROE can turn out to be detrimental to the health of the company.

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#### Why do we need to do DuPont’s Analysis?

• Firstly Dupont’s analysis gives a broader view of the Return on Equity of the company
• Secondly it highlights the company’s strengths and pinpoints the area where there is a scope for improvement. Say if the shareholders are dissatisfied with the lower ROE, the company with the help of the DuPont Analysis formula can assess whether the lower ROE is due to low-profit margin, low asset turnover, or poor leverage.
• Once the management of the company has found the weak area, it may take steps to correct it.
• The lower ROE may not always be a concern for the company as it may also happen due to normal business operations. For instance, the ROE may come down due to accelerated depreciation in the initial years.
• The DuPont equation can be further decompose to have an even deeper insight where the net profit margin is broken down into EBIT Margin, Tax Burden, and Interest Burden.

#### Bottom Line

The Analysis is however important for an investor as it answers the question of what is causing the ROE to be what it is. Likewise if there is an increase in the Net Profit Margin without a change in the Financial Leverage, it shows that the company can increase its profitability. But if the company can increase its ROE only due to an increase in Financial Leverage, it’s risky since the company can increase its assets by taking debt. Thus we need to check whether the increase in the company’s ROE is due to an increase in Net Profit Margin or Asset Turnover Ratio (which is a good sign) or only due to Leverage (which is an alarming signal).

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