Du-Pont Analysis

Learning objectives –
 Understanding the du-pont concept
 Functional break up of model
 Calculating the ratios
 Application of the model
 Du-Pont Analysis
The Dupont analysis also called the Dupont model is a financial ratio
based on the return on equity ratio that is used to analyze 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.
Profit Margin
Total Asset Turnover
Financial Leverage
 Du-Pont Analysis
The Du-Pont Model equates ROE to profit margin, asset turnover, and
financial leverage. The basic formula looks like this –

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 on 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 analyze ROE and the effects different business
performance measures have on this ratio. Investors can analyze 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 Dupont analysis and shouldn’t sway an investor’s opinion of the
company.
 Profitability / Net Profit Margin
Profitability ratios measure the rate at which either sales or capital is converted into
profits at different levels of the operation.
The profit margin ratio, also called the return on sales ratio or gross profit ratio, is a
profitability ratio that measures -

The amount of net income earned with each dollar of sales generated by comparing
the net income and net sales of a company.
In other words, the profit margin ratio shows what percentage of sales are left over
after all expenses are paid by the business.
Creditors and investors use this ratio to measure how effectively a company can
convert sales into net income. Investors want to make sure profits are high enough to
distribute dividends while creditors want to make sure the company has enough
profits to pay back its loans.
 Profitability / Net Profit Margin

Net sales is calculated by subtracting any returns or refunds from gross sales. Net Income equals total
revenues minus total expenses and is usually the last number reported on the income statement.
Example
Trisha’s Tackle Shop is an outdoor fishing store that selling lures and other fishing gear to the public. Last year
Trisha had the best year in sales she has ever had since she opened the business 10 years ago. Last year Trisha’s
net sales were $1,000,000 and her net income was $100,000. Here is Trisha’s return on sales ratio –
 Asset Turnover Ratio

This ratio shows how efficiently a company can use its assets to generate
sales.
The total asset turnover ratio calculates net sales as a percentage of assets to
show how many sales are generated from each dollar of company assets. For
instance, a ratio of .5 means that each dollar of assets generates 50 cents of
sales. Formula -

This ratio measures how efficiently a firm uses its assets to generate sales, so
a higher ratio is always more favorable.
 Asset Turnover Ratio

• Sally’s Tech Company is a tech start up company that manufactures a new tablet
computer. Sally is currently looking for new investors and has a meeting with an
angel investor. The investor wants to know how well Sally uses her assets to
produce sales, so he asks for her financial statements.
Here is what the financial statements reported:
• Beginning Assets: $50,000
• Ending Assets: $100,000
• Net Sales: $25,000
The total asset turnover ratio is calculated like this:
Each dollar of assets generates .33 cents of sales
 Financial Leverage / Equity Multiplier
The equity multiplier/Financial Leverage shows the percentage of assets
that are financed or owed by the shareholders. Conversely, this ratio also
shows the level of debt financing is used to acquire assets and maintain
operations.
The equity multiplier is an indication of company risk to creditors.
Companies that rely too heavily on debt financing will have high debt
service costs and will have to raise more cash flows in order to pay for their
operations and obligations.
Formula-
 Financial Leverage / Equity Multiplier
Analysis
• The equity multiplier is a ratio used to analyze a company’s debt
and equity financing strategy.
• A higher ratio means that more assets were funding by debt than by
equity. In other words, investors funded fewer assets than by
creditors.
• When a firm’s assets are primarily funded by debt, the firm is
considered to be highly leveraged and more risky for investors and
creditors.
• This also means that current investors actually own less of the
company assets than current creditors.
 Financial Leverage / Equity Multiplier
• Tom’s Telephone Company works with the utility companies in the area to maintain
telephone lines and other telephone cables. Tom is looking to bring his company public
in the next two years and wants to make sure his equity multiplier ratio is favorable.
According to Tom’s financial statements, he has $1,000,000 of total assets and $900,000
of total equity. Tom’s multiplier is calculated like this:

• Tom has a ratio of 1.11 This means that Tom’s debt levels are extremely low. Only 10
percent of his assets are financed by debt. Conversely, investors finance 90 percent of
his assets. This makes Tom’s company very conservative as far as creditors are
concerned.
• Tom’s return on equity will be negatively affected by his low ratio, however.