Du Pont ratio analysis provides an effective method for identifying fi rm problems and for using ratios. This method of analysis was developed at the Du Pont Corporation and is now frequently used by analysts. It provides a causal framework for ratio analysis and allows the analyst to draw concrete conclusions about the reasons for high or low profitability.
DuPont analysis is a useful technique used to decompose the different drivers of return on equity (ROE). Decomposition of ROE allows investors to focus on the key metrics of financial performance individually to identify strengths and weaknesses. The big point about Du Pont analysis is that return on equity (ROE) results from trade-off between margin, volume, and leverage.
The firm can change its ROE by adjusting any one of three components:
- It can have high turnover of its product.
- It can have large margins on each sale.
- It can be highly leveraged.
The Du Pont analysis computes the ROE as the product of margin, turnover, and leverage:
The equity multiplier, as shown below, is a measure of the firm’s leverage. We can rewrite the Du Pont relationship using the ratio formulas as follows:
There is nothing mystical about this equation. With a little algebra, it collapses to net income divided by equity, which is just the equation for the ROE. However, it is extremely useful as a tool to establish a beginning point for analysis. Whether the ROE is declining, or not as high as the firm’s competitors, determines if the problems are with the margin, turnover, or leverage of the fi rm. Note that high leverage may mask problems with margin and turnover. Once you have located the problem, examine the inputs to the troublesome ratio for additional clues.
Figure below can be used to track the source of the problem through ratios.
The DuPont Analysis is important determines what is driving a company's ROE; Profit margin shows the operating efficiency, asset turnover shows the asset use efficiency, and leverage factor shows how much leverage is being used. The method goes beyond profit margin to understand how efficiently a company's assets generate sales or cash and how well a company uses debt to produce incremental returns.
Using these three factors, a DuPont analysis allows analysts to dissect a company, efficiently determine where the company is weak and strong and quickly know what areas of the business to look at (i.e., inventory management, debt structure, margins) for more answers. The measure is still broad, however, and is not a substitute for detailed analysis.