DuPont Analysis1

From a shareholders’ point of view the aim of the management should be to maximise
shareholders’ wealth. One way of doing that is by increasing the Return on Equity (RoE).

Entrepreneurs seek various ways of improving business. Whatever way they choose, it
should contribute in some way to improving RoE. RoE can be broken up into many
components as shown in the subsequent paragraphs. Each initiative that the
entrepreneur takes may have a different effect on each component.

𝑃𝐴𝑇
We know that: 𝑅𝑜𝐸 =
𝑁𝑊

Where PAT is Profit After Tax and NW is Net Worth of the company, also referred to as
total shareholders’ equity.

This can be broken up into a function of Net Margin, Asset Turnover and Leverage as
below:
𝑃𝐴𝑇 𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠
𝑅𝑜𝐸 = ( )( )( )
𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠 𝑁𝑊

The net margin in turn depends on the tax effect (tax rate, tax shelter), interest expense
and operating margin. The expanded equation is shown below:
𝑃𝐴𝑇 𝑃𝐵𝑇 𝐸𝐵𝐼𝑇 𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠
𝑅𝑜𝐸 = ( )( )( )( )( )
𝑃𝐵𝑇 𝐸𝐵𝐼𝑇 𝑆𝑎𝑙𝑒𝑠 𝐴𝑠𝑠𝑒𝑡𝑠 𝑁𝑊

RoE can be improved by increasing any of the above terms. But some of them may have
counter-balancing effects on the others. If you are considering an investment it would be
beneficial to see how it would affect the RoE components given above. The benefits can
be immediate or delayed (long term), but there should be some benefits for the
investment to make sense.
𝑃𝐴𝑇
The first term ( ) denotes the tax efficiency of the firm. The lower the effective tax
𝑃𝐵𝑇
rate of the company the higher it would be. The company can increase the ratio by, for
example, setting up a factory in a tax sheltered location. Of course, the easiest way to
avoid taxes is to show a loss, but we don’t want to be in that situation!
𝑃𝐵𝑇
The second term ( ) denotes the interest cost of the firm as a percentage of its
𝐸𝐵𝐼𝑇
operating profit. The lower the interest cost, the higher the ratio. To increase this ratio,
the firm would need to reduce its cost of debt. Startups have very little flexibility in
reducing the cost of debt. However, a security or highly rated guarantor can help reduce
the cost of debt.
𝐸𝐵𝐼𝑇
The third term ( ) is the operating margin. This is arguably the most important ratio.
𝑆𝑎𝑙𝑒𝑠
Sustaining high operating margins is the most effective way of delivering shareholder
value. This can be achieved by improving operational efficiencies (reducing costs),
differentiation (higher prices) or through economies of scale or scope.

1
This note is prepared for classroom discussion only by Prof G Kanti Kumar.

1
 𝑆𝑎𝑙𝑒𝑠
The fourth term ( ) is the asset turnover. Vertical integration has the tendency to
𝐴𝑠𝑠𝑒𝑡𝑠
increase the assets held and thereby reduce asset turnover. A company with high
outsourcing tends to have a high asset turnover. This needs to be weighed with the
decrease or increase in operating margin.
𝐴𝑠𝑠𝑒𝑡𝑠
The fifth term ( ) is financial leverage. This is probably the easiest to increase! The
𝑁𝑊
firm can increase it by borrowing more. However, it has an adverse effect on the second
term. The net effect should be weighed and this ratio should not be evaluated alone.
Beyond a point, leverage can throw the company into financial distress.

The above is an illustration of some effects of different types of mergers on each

component of RoE. Focusing attention on the RoE components is one way to bring more
rationality into our investment decisions. There is also the other thing we need consider
– the risk.