Role of DuPont Analysis in Assessing Company's Earning Power

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What is DuPont Analysis?

The DuPont Analysis is a financial model that offers insight into the basic performance of a company. It breaks down the Return on Equity (ROE) into three key individual metrics to do so. The DuPont analysis is a product of asset turnover, gross profit margin, and operating leverage.

Simply put,

$$\mathrm{ROE\, =\, Net\: Profit\: Margin\, \times \, Assets\: Turnover\, \times\, Equity \: Multiplier}$$

It may be noted here that the ROE of a company is considered as its earning power. Another component that is considered as a part of earning power of a company is the Return on Assets (ROA).

Net Profit Margin

The calculation of Net Profit Margin is performed by dividing net income by net revenue.

$$\mathrm{Net\: Profit \: Margin\, =\, \frac{Net\: Income}{Net \: Revenue}}$$

Net profit margin shows the remaining profits that a business has after deducting the expenses. It is the percentage of profit for every rupee of revenue invested in the business. When the net profit margin of a business increases, its ROE too goes up.

The basic idea behind net profit margin is that a company can increase its profits by increasing the prices, reducing the costs, or by a combination of both of these factors.

Total Assets Turnover

Total Assets Turnover shows the capability of a company to convert its assets into sales. Total assets turnover is obtained by dividing the company’s revenues by the average assets of the company. A business’s ROE increases with the increase of Total Assets Turnover.

The Total Assets Turnover is inversely proportional to the net profit margin of a company. When Net Profit Margin increases, the value of Total Assets Turnover goes down.

The relationship between net profit margin and total assets turnover makes it possible for the investors and analysts to compare the business models of low-volume high-profit businesses to low-profit high-volume ones. This lets the shareholders determine which of the companies they want to invest in are better at driving ROE.

Equity Multiplier

Equity Multiplier represents the financial leverage of a company and the company’s ROE arising due to the debt of the company. The equity multiplier is obtained by dividing the average total assets by the average shareholder’s equity.

$$\mathrm{Equity\: Multiplier\, =\, \frac{Average\: Assets}{Average \: Equity}}$$

An increase in Equity Multiplier increases the ROE. However, as the companies try to keep themselves away from acquiring too much debt, the value of the equity multiplier remains low.

Role of DuPont Analysis in Assessing Company's Earning Power

The DuPont analysis provides a good understanding of a company’s earnings power via its three components.

They are as follows −

• The first component - Net Profit Margin shows the ability of a company to derive profit by reducing costs and/or increasing prices which shows that there is the demand for the company’s products in the market.

• The second component - Total Assets Turnover shows which type of business would suit the company? Is it a high volume low-profit model or a low-volume high-profit model that suits the business? This understanding can help the management resolve issues that may affect the business in the future.

• The third component - Equity Multiplier helps the business owners to see the optimum debt-equity mix that can be used for their businesses. Usually, a higher Equity Multiplier ratio can increase ROE, but companies should remain alert so that the value of the equity multiplier does not go above certain limits. The increase of Equity Multiplier beyond given limits may mean that the company has debt that is more than its serviceable limits.

The DuPont model always gives an accurate idea of the composition of debt and equity of a company that is invested in specific projects.

Updated on 17-May-2022 08:52:39