DuPont Analysis: Definition, Benefits and How to Calculate

# DuPont Analysis: Definition, Benefits and How to Calculate

The DuPont Analysis is a framework used to analyze a company’s financial performance through an examination of its return on equity (ROE).

The DuPont Analysis reduces ROE down into three components – net profit margin, total asset turnover and financial leverage – to arrive at an overall percentage score.

Also referred to as the DuPont model or identity, the DuPont method or the strategic profit model, this framework was developed by the DuPont Corporation in the 1920s.

It is a well-respected formula used by company financial managers, independent financial advisors and investors alike.

## What Is ROE?

ROE is an indication of how profitable a company is in relation to its equity; how well is shareholder equity utilized to generate profit?

ROE represents the percentage of profit that is generated by each dollar of shareholder equity.

For instance, an ROE of 20% means that each dollar of shareholder equity generates 20 US cents profit.

## What Is a Good or Bad ROE Score?

The answer to this question is completely contextual. What makes a good or bad ROE cannot be decided without comparison to other companies in the same industry.

Generally, a good ROE is equal to or higher than the average for the company’s industry or sector.

This is why ROE is not a good indicator of equity-related profitability when comparing companies across different industries.

## Why Are Investors Interested in ROE?

When an investor considers which company to invest in, two key factors of interest are:

• What level of dividend payment will they receive?
• Is the company likely to have a sustainable growth rate?

A company’s ROE can be used to inform both of these factors.

For instance, it is possible to calculate a company’s future growth rate by multiplying ROE by retention ratio.

The retention ratio is the percentage of net income reinvested or retained to support the company’s future growth:

Future growth = ROE × retention ratio

## What Can the DuPont Analysis Tell You?

By breaking down a company’s ROE into the three drivers – net profit margin, total asset turnover and financial leverage – the DuPont Analysis can be used to discover which financial activities have the greatest effect on the company’s financial performance.

The DuPont Analysis is commonly used by companies to examine their own financial performance, but it can also be useful to investors who wish to check on a company’s equity-related profitability before making an investment.

Additionally, financial advisors may use the DuPont analysis to serve their customers.

The main benefit of the DuPont analysis is the additional insight provided by drilling down into the drivers of ROE: net profit margin, total asset turnover and financial leverage.

## Understanding the DuPont Formulas

The starting point of the DuPont analysis is the ROE formula, which divides net income by shareholder equity:

ROE = net income ÷ shareholder equity

The DuPont analysis framework offers further insight than the basic ROE formula by adding factors to the calculation such as sales, assets and tax rates.

The DuPont analysis is available in two formats – a three step formula and a five step formula.

### Three Step Formula

The three step DuPont analysis formula calculates ROE using the following factors:

• Net income
• Sales
• Assets
• Shareholder equity

The three step formula is:

ROE = (net income ÷ sales) × (sales ÷ assets) × (assets ÷ shareholder equity)

This formula can also be expressed as:

ROE = net profit margin × asset turnover × equity multiplier

Net profit margin measures profit as a percentage of revenue. Asset turnover measures how well assets are used to generate revenue or income. Equity multiplier (financial leverage) measures the proportion of assets funded by stockholder equity and is a risk indicator.

### Five Step Formula

The five step DuPont analysis formula separates operating activities from financing activities to discover how each affects ROE. This is especially useful where a company’s ROE has changed detrimentally.

The five step formula uses the following factors:

• Earnings before tax
• Sales
• Assets
• Equity
• Tax rate

The five step formula is:

ROE = (earnings before tax ÷ sales) × (sales ÷ assets) × (assets ÷ shareholder equity) × (1 – tax rate)

This formula can also be expressed as:

ROE = operating profit margin × asset turnover × equity multiplier × tax retention rate

Operating profit margin is a measure of how much profit a company makes on its sales after the payment of production costs, such as employee wages, but before interest or tax are deducted.

## DuPont Analysis Example

### Basic ROE Calculation Example

ROE = net income ÷ shareholder equity

If the net income is \$86,000 and shareholder equity is \$420,000, the calculation looks like this:

ROE = 86,000 ÷ 420,000 = 20.47%

### Three Step Formula DuPont Analysis Calculation Example

ROE = (net income ÷ sales) × (sales ÷ assets) × (assets ÷ shareholder equity)

ROE = net profit margin × asset turnover × equity multiplier

• Net income = \$86,000
• Sales = \$410,000
• Assets = \$460,000
• Shareholder equity = \$420,000

Divide net income by sales:

Net profit margin = 86,000 ÷ 410,000 = 20.97%

Divide sales by assets:

Asset turnover = 410,000 ÷ 460,000 = 0.89

Divide assets by shareholder equity:

Equity multiplier = 460,000 ÷ 420,000 = 1.09

Multiply the three amounts:

ROE = 20.97% × 0.89 × 1.09 = 20.34%

### Five Step Formula DuPont Analysis Calculation Example

ROE = (earnings before tax ÷ sales) × (sales ÷ assets) × (assets ÷ shareholder equity) × (1 – tax rate)

This formula can also be expressed as:

ROE = operating profit margin × asset turnover × equity multiplier × tax retention rate

• Earnings before tax = \$100,000
• Sales = \$410,000
• Assets = \$460,000
• Shareholder equity = \$420,000
• Tax rate = 22%

Divide earnings before tax by sales:

Operating profit margins = 100,000 ÷ 410,000 = 0.24

Divide sales by assets:

Asset turnover = 410,000 ÷ 460,000 = 0.89

Divide assets by equity:

Equity multiplier = 460,000 ÷ 420,000 = 1.09

Calculate the tax retention rate:

Tax retention rate = 100% – 22% = 78%

ROE = 0.24 × 0.89 × 1.09 × 78% = 18.16% DuPont Analysis: Definition, Benefits and How to Calculate

The purpose of the DuPont analysis framework is to measure a company’s financial performance through an examination of its return on equity (ROE).

The DuPont analysis breaks ROE down into net profit margin, total asset turnover and financial leverage to arrive at an overall percentage score – for example, 17%.

By breaking down a company’s ROE into the three main drivers – net profit margin, total asset turnover and financial leverage – the DuPont analysis can be used to indicate which financial activities have the greatest effect on a company’s financial performance.

The main benefit of the DuPont analysis is the additional insight provided by drilling down into the drivers of ROE: net profit margin, total asset turnover and financial leverage.

The DuPont analysis framework is commonly used by companies to examine their equity-related financial performance.

Additionally, it can be a useful method for investors to check on a company’s profitability before making an investment. Financial advisors may also use the DuPont analysis framework to serve their customers.

There are four main problems with using DuPont analysis. These are:

1. The formula relies on the figures used, such as sales or assets, being accurate and current to the same timeframe as each other.

2. A level of knowledge about the company, the industry it is part of and the company’s competitors is required to effectively judge whether the ROE percentage is good or bad in comparison to other companies.

3. There may be seasonal factors that affect figures used in the DuPont analysis formula, such as the holding of a larger inventory in anticipation of Christmas, for instance.

4. It is difficult to use ROE to compare companies in different industries.

The three main components of the DuPont analysis framework are net profit margin, total asset turnover and financial leverage.

Net profit margin is a measure of profit as a percentage of revenue. Asset turnover is a measure of how effectively a company’s assets are used to generate revenue or income.

Financial leverage (represented by the term ‘equity multiplier’ in the DuPont analysis framework) measures the proportion of assets funded by stockholder equity instead of debt and is used as a risk indicator.

The basic ROE formula takes into account two factors in their overall state, that is, the company’s net income and its shareholder equity:

ROE = net income ÷ shareholder equity

By comparison, the DuPont analysis framework arrives at the ROE by considering its driving factors – net profit margin, total asset turnover and financial leverage.

This is done through the three step formula:

ROE = (net income ÷ sales) × (sales ÷ assets) × (assets ÷ shareholder equity)

also expressed as:

ROE = net profit margin × asset turnover × equity multiplier

or the five step formula:

ROE = (earnings before tax ÷ sales) × (sales ÷ assets) × (assets ÷ shareholder equity) × (1 – tax rate)

also expressed as:

ROE = operating profit margin × asset turnover × equity multiplier × tax retention rate

Return on assets (ROA) is an indicator of how well a company’s assets generate revenue. This is a separate but contributing factor to ROE.

The three step DuPont analysis formula uses net profit margin, total asset turnover and financial leverage (expressed as equity multiplier) to arrive at ROE, factoring in net income, sales, assets and shareholder equity to arrive at these three figures.

The five step DuPont analysis formula separates operating activities from financing activities to discover how each affects ROE.

It uses operating profit margin, asset turnover, financial leverage (expressed as equity multiplier) and tax retention rate to calculate ROE, factoring in earnings before tax, sales, assets, shareholder equity and tax rate.

The ROE result is different depending on whether the basic ROE formula or the three or five step DuPont analysis is used because of the factors included in the calculation.

Progressing from the ROE formula to the three step and then five step formula, more factors are included and hence the ROE result is more exact.

In addition, the DuPont analysis offers insight into the drivers of ROE, whether that be net profit margin, financial leverage or asset turnover.

If you use the three step DuPont analysis formula, information required includes:

• Net income
• Sales
• Assets
• Shareholder equity

If you use the five step DuPont analysis formula, information required includes:

• Earnings before tax
• Sales
• Assets
• Shareholder equity
• Tax rate

## Final Thoughts

Whether you are an investor, a financial manager working within an organization or an independent financial advisor, ROE is an effective indicator of a company’s equity-related profitability.

The DuPont analysis framework offers the opportunity to drill down into the main drivers of ROE to discover which has the greatest effect on profitability, whether historically, currently or in the future.