DuPont analysis breaks down the components of the return on equity formula to reveal the different ways in which a business can alter its return on equity. This analysis is used by organizations that want to enhance the returns that they provide to investors. The name is derived from the DuPont Corporation, which invented this analysis in the early 1900s.
Return on equity (ROE) is essentially net income divided by shareholders’ equity. ROE performance can be enhanced by focusing on improvements to the three underlying measurements that roll up into ROE. These sub-level measurements, which form the core of DuPont analysis, are:
- Profit margin. Calculated as net income divided by sales. Can be improved by trimming expenses, increasing prices, or altering the mix of products or services sold.
- Asset turnover. Calculated as sales divided by assets. Can be improved by reducing receivable balances, inventory levels, and/or the investment in fixed assets, as well as by lengthening payables payment terms.
- Financial leverage. Calculated as assets divided by shareholders’ equity. Can be improved by buying back shares, paying dividends, or using more debt to fund operations.
The multiple components of the ROE calculation present an opportunity for a business to generate a high ROE in several ways. For example, a grocery store has low profits on a per-unit basis, but turns over its assets at a rapid rate, so that it earns a profit on many sale transactions over the course of a year. Conversely, a manufacturer of custom goods realizes large profits on each sale, but also maintains a significant amount of component parts that reduce asset turnover.
Usually, a successful business is able to focus on either a robust profit margin or a high rate of asset turnover. If it were able to generate both, its ROE would be so high that the company would likely attract competitors who want to emulate the underlying business model. If so, the increased level of competition usually drives down the overall ROE in the market to a more reasonable level.
A high level of financial leverage can increase ROE, because it means a business is using the minimum possible amount of equity, instead relying on debt to fund its operations. By doing so, the amount of equity in the denominator of the return on equity equation is minimized. If any profits are generated by funding activities with debt, these changes are added to the numerator in the equation, thereby increasing the return on equity.
The trouble with employing financial leverage is that it imposes a new fixed expense in the form of interest payments. If sales decline, this added cost of debt could trigger a steep decline in profits that could end in bankruptcy. Thus, a business that relies too much on debt to enhance its shareholder returns may find itself in significant financial trouble. A more prudent path is to employ a modest amount of additional debt that a company can comfortably handle even through a business downturn.
DuPont analysis does not favor the use of any one of these alternatives – it merely points out the options available for altering ROE.
A case can be made that the DuPont analysis should be ignored, since an excessive focus on it may drive management to reduce a number of discretionary expenses that are needed to build long-term value, or to use an excessive amount of debt, or to cut away assets that are actually needed. Thus, the analysis should be used with caution.
