The DuPont Corporation developed this analysis in the 1920s. The name has stuck with it ever since. The DuPont analysis is also called the DuPont model. It is a financial ratio based on the return on equity ratio that is used to analyse a company's ability to increase its return on equity. In other words, this model breaks down the return on equity ratio to explain how companies can increase their return for investors. The DuPont analysis looks at three main components of the ROE ratio.
1. Profit Margin
2. Total Asset Turnover
3. Financial Leverage
Based on these three performances measures the model concludes that a company can raise its ROE by maintaining a high-profit margin, increasing asset turnover, or leveraging assets more effectively.
Formula
The DuPont Model equates ROE to profit margin, asset turnover, and financial leverage. The basic formula looks like this.
Return on Equity = Profit Margin x Total Asset Turnover x Financial Leverage
Since each one of these factors is a calculation in and of itself, a more explanatory formula for this analysis looks like this.
Every one of these accounts can easily be found in the financial statements. Net income and sales appear on the income statement, while total assets and total equity appear on the balance sheet.
Analysis
This model was developed to analyse ROE and the effects different business performance measures have on this ratio. So investors are not looking for large or small output numbers from this model. Instead, they are looking to analyse what is causing the current ROE. For instance, if investors are unsatisfied with a low ROE, the management can use this formula to pinpoint the problem area whether it is a lower profit margin, asset turnover, or poor financial leveraging.
Once the problem area is found, management can attempt to correct it or address it with shareholders. Some normal operations lower ROE naturally and are not a reason for investors to be alarmed. For instance, accelerated depreciation artificially lowers ROE in the beginning periods. This paper entry can be pointed out with the analysis and shouldn't sway an investor's opinion of the company.
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