Retrun on equity capital (ROE) is a measure that shows how a company has generated return on its equity capital. To understand what are the factors that has increased or decreased the company’s ROE, a usefule technique is to decompose ROE into its compnent parts. DuPont analysis is a method of breaking down return on equity (ROE) into their components to measure which areas are responsible for company’s performance.
This method is popularized by DuPont corporation to analyze the fundamental performance of the company. It’s also known as DuPont model.
ROE is one of the most important indicator to analyze company’s profitability. To know how it’s measured, let us breakdown return on equity ratio:
ROE = net profit / shareholders capital
Return on equity ratio measures how much net profit a company generate on it’s shareholders capital.
Two companies can have same return on equity but DuPont analysis can let you know which company is generating more profit with less risk.
To measure components of ROE, multiply above equation by revenue/revenue or sales/sales.
ROI = (net profit / revenue) * (revenue / shareholders capital)
= net profit margin * equity turnover
Return on equity can be divided to three components by multiplying assets/assets. To see how it’s used, let’s take a look at the ROE formula by multiplying assets/assets:
ROE = ( net earnings / revenue ) * ( revenue / total assets ) * ( total assets / shareholders capital)
Return on equity =Net profit margin * asset turnover * leverage
Above equations in DuPont analysis indicates following three major financial ratios that measure return on equity or ROE of a company;
- Operating efficiency: net profit margin measures the operating efficiency of the company. It tells you how much income a company derives per one money unit of sales.
- Assets use efficiency: How much revenue a company generates per one money unit of assets.
- Financial leverage: Its an indicator of solvency. It measure the total amount of a company’s assets relative to its equity capital.
Net profit margin is calculated by dividing after-tax net earning by total revenues. It measures the operating efficiency of the company. To have a positive impact on ROE, you can improve net profit margin by reducing cost or by increasing price of the products.
Assets turnover ratio represents how effectively the company is using its assets to make money.
Financial leverage is an analysis of company’s debt to finance its assets.
By analyzing return on equity through DuPont analysis, you can analyze company’s ability to increase its ROE. Company’s ROE can be increased by maintaining higher net profit margin, increasing return on assets and by leveraging assets more effectively. If ROE is low, it must be due to one of the following reasons;
- Low net profit margin,
- Poor asset turnover, or
- Low leverage
Decomposing ROE is a useful way to analyse the change in return on equity capital over time for a given company and for differences in ROE for different companies in a given time period. DuPont analysis helps the management to find out which areas they should focus on to improve ROE.
