IMBA SEMESTER 5: FINANCIAL MANAGEMENT

DuPont Analysis
DuPont Analysis is an approach which breaks the Return on Equity (ROE) into more
detailed expression, thereby overcoming the shortcomings or loopholes of conventional
ROE. It was developed by DuPont Corporation in the 1920s. DuPont analysis interprets the
basic ROE ratio in a manner so that it provides a great insight into the performance of the
company.
How to Calculate ROE?

It is the profit that a company derives for every dollar invested by the shareholders in the
company. ROE or Return on Equity is given by:
Return on Equity (ROE) = Net Income
Shareholders’ Equity

Net Income = Net profit derived from the business

Shareholders’ Equity = Capital invested by shareholders of the company
ROE is a simple ratio and requires only 2 figures to calculate viz. Net Income and
Shareholders Equity. Higher this ratio, better are the returns that shareholders get for
every dollar invested. So, ideally from an investor’s point of view, Return on Equity should
be as high as possible.

ROE focuses only on the returns of the equity shareholders. It only measures a percentage
rate of return earned by the investors from the underlying company. Therefore, the scope
of this ratio is quite narrow.

On the contrary, the ratio is converted into an expression by DuPont which not only
presents the returns earned by the investors but also talks about three important
parameters about a company’s performance.

These three parameters are

Profitability,
Operating Efficiency / Asset Utilization, and
Financial Leverage.

Formula of DuPont Analysis

DuPont Analysis overcomes this drawback of ROE.

It breaks ROE into 3 parts; thereby one can analyze the reason for increase/decrease in
ROE.
Net Income Sales Assets
ROE X
= Sales X Shareholder’s
Assets
Equity

Prepared by: Prof. Khyati Trivedi

IMBA SEMESTER 5: FINANCIAL MANAGEMENT

The above equation for ROE is broken down into 3 components:

i. Net Income / Sales = Operating Efficiency (as measured by profit margin).

ii. Sales / Assets = Asset Utilization (as measured by total asset turnover).
iii. Assets / Shareholders’ Equity = Financial leverage (as measured by the equity
multiplier).

Use of DuPont Analysis

Using the modified equation of Return on Equity, one can make a more informed decision
and understand the company position better. If the Return on Equity either increases due
to increase in operating efficiency or improved asset utilization, it is a good sign for
investors. It would imply that either company is making higher margins on its sales or the
company is making better use of its assets or both.

On the other hand, if the Return on Equity increases on account of financial leverage, it
would imply that the profit is due to the financial strategy of the company rather than good
operations of it. Too higher a debt ratio also makes a company riskier proposal for
investment.

In essence, a manager should try increasing the ROE by way of either higher operating
efficiency or better asset utilization. There is no reservation for using the third parameter
also i.e. financial leverage, but it will increase the risk of bankruptcy in case the lenders
asks for the large sum of money.

Example Explaining DuPont Analysis

Consider a hypothetical scenario of companies X and Y with below numbers.

X Y
1. Operating profit margin 0.20 0.12
ratio
2. Asset turnover ratio 0.30 0.30
3. Financial Leverage or 2.00 3.33
Equity multiplier
ROE (1*2*3) 0.12 0.12

ROE for both the companies is same viz. 12%. But company X has better Operating margin
as compared to company Y. Hence, X can be considered as a safer option to invest in as
compared to Y.

DuPont analysis is a potentially helpful tool for analysis that investors can use to make

Prepared by: Prof. Khyati Trivedi

IMBA SEMESTER 5: FINANCIAL MANAGEMENT

more informed choices regarding their equity holdings. The primary advantage of DuPont
analysis is the fuller picture of a company's overall financial health and performance that it
provides, compared to more limited equity valuation tools. A main disadvantage of the
DuPont model is that it relies so heavily on accounting data from a company's financial
statements, some of which can be manipulated by companies, so they may not be accurate.

While the DuPont analysis model can be a very helpful tool for investors, it is not without
its weaknesses. The expansive nature of the DuPont analysis means that it requires several
inputs. As with any calculation, the results are only as good as the accuracy of the inputs.
Financial ratios are always best evaluated on a comparison basis, showing how well a
company is performing compared to its closest business peers or how well the company is
doing in comparison with its own historical performance.

Seasonal factors, depending on the industry, can also be an important consideration, since
these factors can distort ratios. Some companies always carry a higher level of inventory at
certain times of the year, for example. Different accounting practices between companies
can also make accurate comparisons difficult.

Prepared by: Prof. Khyati Trivedi