Du-Pont Analysis

By: Madan rajput Devendra Jain

What Does DuPont Analysis Mean?

An expression that breaks return on equity (ROE) down into three parts: profit margin, total asset turnover and financial leverage. It is known as "DuPont Analysis".

A method of performance measurement that was started by the DuPont Corporation in the 1920s. With this method, assets are measured at their gross book value rather than at net book value in order to produce a higher return on equity (ROE). It is also known as "DuPont identity".

Definition

DuPont  Analysis is an approach to analyze the firm by evaluating inter relationships among many of the performance measures. In the Du-Pont Analysis we try to find out what are the factors/drivers that are causing the profits to move up. By identifying these factors/drivers we can concentrate on them and improve our efficiency.

The three components of DuPont measure the profitability, efficiency and the degree of leverage of the firm. The DuPont chart makes an intra firm comparison among these three parameters for three years.

Du-pont identity

DuPont identity tells us that ROE is affected by three things: - Operating efficiency, which is measured by profit margin- Asset use efficiency, which is measured by total asset turnover- Financial leverage, which is measured by the equity multiplier(ROE = Profit Margin (Profit/Sales) * Total Asset Turnover (Sales/Assets) * Equity Multiplier (Assets/Equity)) 

The Elements of the DuPont Analysis

Net Profit Margin:It offers an indication of how much profit a company makes for every dollar of

revenue it generates. While profit margins vary by industry, in general, the higher a company’s profit margin compared to its competitors, the better.

Asset Turnover: It provides a measure of a firm’s efficiency in the use of its assets in to

generate revenue. The higher the number the better. Looking at asset turnover can also help an investor to understand the company’s pricing strategy as companies with lower profit margins tend to see higher asset turnover.

Equity Multiplier: It is used to measure of financial leverage, allowing the investor to determine

what portion of the ROE is the result of debt. Savvy investors understand that it is possible for a company with weak sales results and poor margins to artificially increase its ROE by taking on an extraordinary amount of debt.

Du Pont analysis factor Factor’s CalculationAssets Turnover Revenue / Average Assest

Profitability Interest EBIT / Revenue

Interest Burden (EBIT - Interest Exp.)/ EBIT

TaX Efficiency 1 - Tax Exp./(EBIT - Interest Expenses

Leverage Avg. Assets / Avg. Equity

Importance of Du-Pont Analysis

Understanding the relationship among various ratio’s such as turnover ratio, leverage ratio and profitability ratio’s

Decision regarding product prices, per unit cost, volume or efficiency, ratio of debt’s and equity used.

To know financial position, cost of capital of company or improve it.

Helpful in risk adjustment Evaluate as every business is competing for limited

capital resources. Operating performance can be argumented.

Application of dupont analysis

1. High turnover industries:- Groceries, IT industries, pharmaceutical,

hospitality2. High margin industries:- Fashion industry, Airlines industry, television,

business institute, Digital music product industries

3. High leverage industries:- Financial sector, Real estate (silicon valley),

banking sector.

Depicted Du Pont analysis through chart:

Du-pont model

Three major formula’s in dupont analysis

1. Operating Profit Margin Ratio = Net Farm Income from Operations + Interest Expense - Value

of Unpaid Labor and Management Divided by

Gross Revenue (Value of Farm Production)2.Asset Turnover Ratio =

Gross Revenue (Value of Farm Production) Divided by

Average Farm Assets3.Equity Multiplier =

Average Farm Assets Divided by

Average Farm Equity

Du Pont analysis chart

Dupont analysis case study on Hero-Honda Return on net worth in Hero Honda

Return on Capital employed in Hero Honda

Return on total assets In Hero Honda

Following fact’s are stand out from du pont analysis of Hero Honda

Its cogs/sales ratio has fallen from 85%  in 01-02 to 82% in 03-04. This reflects the large scale cost reduction measures initiated by Hero Honda. In this tough competition cost reduction is the only option available for increasing the profits.

Its sales/FA ratio increased from 925% in 01-02 to 1019% in 03-04.  This shows that Hero Honda is able to generate more sales from same amount of Fixed assets. It shows that they are also undertaking measures to increase productivity.

Its sales/cash ratio has increased from 4166% to 16157%, which reflects the after effect of a sound cash management policy. The company is maintaining cash which is optimum, considering its future plans.

The sales/debtors ratio has also increased, which shows the  efficient credit and follow up procedure.

Sales/inventories ratio rose to 3186% in 03-04 from 2545% in 01-02,  This is also the effect of  working capital management policies.

DuPont Analysis for Two Farms

Farmer A Farmer B1. Operating profit margin ratio (OPMR)

0.30 0.12

2. Assets turnover ratio(ATO) 0.20 0.363. ROA (1*2) 0.060 0.0434. Interest expenses to avg. farm assets

0.05 0.03

5. Equity multiplier 2.00 1.506. ROE (3-4) * 5 0.02 0.02

Conclusion of farm comparison Farmer A and Farmer B each have a 2 % ROE. However, the levers of

the DuPont system indicate that the sources of the weakness are different. Farmer A has a stronger operating profit margin ratio but lower asset turnover compared to Farmer B. Furthermore, Farmer A has a higher leverage ratio (equity multiplier) than Farmer B.

The weak ratios for each farm may be decomposed into components to determine the potential sources of the weakness. To improve asset turnover Farmer A needs to increase production efficiency or price levels or reduce current or noncurrent assets. To improve profit margins, Farmer B needs to increase production efficiency or price levels more than costs or reduce costs more than revenue.

The DuPont analysis is an excellent method to determine the strengths and weaknesses of a farm. A low or declining ROE is a signal that there may be a weakness. However, using the DuPont analysis can better determine the source of weakness. Asset management, expense control, production efficiency or marketing could be potential sources of weakness within the farm. Expressing the individual components rather than interpreting ROE itself may identify these weaknesses more readily.

ConclusionThe types of analysis that examines a company’s return on

equity (ROE) by breaking it into three main component’s:1.Profit margin 2. Assets turnover 3. financial leverage factor. By breaking the ROE into three distinct part’s, investor can

examines how effectively a company is using equity, since poorly performing component’s will drag down the overall figure. To calculate a firm ROE through Du pont analysis

Multiply the profit margin (net income divided by sales), Assets turnover (sales divided by assets), and leverage factor

( total assets divided by shareholder equity) together. The higher the result the higher the return on equity.

(ROE= Profit margin * Assets turnover * Leverage factor)