Financial statement analysis is employed for a variety of reasons. Outside investors are seeking information as to the long run viability of a business and its prospects for providing an adequate return in consideration of the risks being taken. Creditors desire to know whether a potential borrower or customer can service loans being made. Internal analysts and management utilize financial statement analysis as a means to monitor the outcome of policy decisions, predict future performance targets, develop investment strategies, and assess capital needs. As the role of the credit manager is expanded cross-functionally, he or she may be required to answer the call to conduct financial statement analysis under any of these circumstances. The DuPont analysis is a useful tool in providing both an overview and a focus for such analysis.
History of DuPont Analysis
The DuPont model of financial analysis was made by F. Donaldson Brown, an electrical engineer who joined the giant chemical company’s Treasury department in 1914. A few years later, DuPont bought 23 percent of the stock of General Motors Corp. and gave Brown the task of cleaning up the car maker’s tangled finances. This was perhaps the first large-scale re-engineering effort in the USA. Brown devised formulae to analyse the source of shareholder returns generated by these companies. These formulae or methods came to be known as DuPont system of analysis. Ensuing success launched the DuPont model towards prominence in all major U.S. corporations. It remained the dominant form of financial analysis until the 1970’s. The DuPont analysis is known by many other names, including DuPont Equation, DuPont Framework, DuPont Identity, DuPont Model, DuPont Method, or Strategic Profit Model.
Framework of DuPont Analysis
The DuPont Analysis is a wonderful synthesis of the different ratios to end up with the Return on Equity (ROE). ROE effectively measures how much profit a company can generate on the equity capital investors have deployed in the business, and can be used over time to evaluate changes in a company’s financial situation. Simply, ROE indicates the amount of earnings generated by each dollar of equity. It can be a valuable insight into a company’s operations. In general, the higher the ROE the better, as high ROE companies, all other things being equal, will produce more earnings and free cash flow that can be used to support a higher level of growth, keep the company financially strong, and provide cash returns to shareholders.
The DuPont analysis breaks down a company’s return on equity (ROE) into three components.
- Profit Margin as measured by net income as a percentage of sales (net profit/sales)
- Asset Turnover which is net sales divided by the total assets of a firm (sales/assets)
- Degree of Financial Leverage as measured by the equity multiplier which is the ratio of total assets financed by stockholders’ equity (assets/equity)
Under DuPont analysis, Return on Equity (ROE) is equal to the Profit Margin multiplied by Asset Turnover multiplied by Financial Leverage.
Return on Equity (ROE) = Profit Margin x Asset Turnover x Financial Leverage = (Net Profit/Sales) x (Sales/Assets) x (Assets/Equity)
- Profit margin is an indicator of a company’s pricing strategies and how well the company controls costs. Profit margin is calculated by finding the net profit as a percentage of the total revenue. If the profit margin of a company increases, every sale will bring more money to a company’s bottom line, resulting in a higher overall return on equity. Even though the common consensus is that the higher the net profit margin the more preferable it is, executives may often intentionally decrease this ratio this in an attempt to attract an increase in sales.
- Asset turnover, on the other hand, measures the efficiency of the company in generating sales for every dollar of asset. Asset turnover tends to have an inverse relationship with profit margin, meaning that if a firm has a high profit margin it generally has a low asset turnover. Similar to profit margin, if asset turnover increases, a company will generate more sales per asset owned, once again resulting in a higher overall return on equity.
- Lastly, the equity multiplier of Financial Leverage shows how leveraged a company is by computing how much financing stockholders provided for every dollar of asset. As was the case with asset turnover and profit margin, increased financial leverage will also lead to an increase in return on equity. This is because the increased use of debt as financing will cause a company to have higher interest payments, which are tax deductible. Because dividend payments are not tax deductible, maintaining a high proportion of debt in a company’s capital structure leads to a higher return on equity.
Breaking ROE into these three parts allows evaluation of how well one can manage the company’s assets, expenses, and debt. Financial managers have basically three ways of improving operating performance in terms ROE. These are:
- Increase operating profit margins
- Increase capital asset turnover
- Change financial leverage
The above DuPont equation is the 3 step DuPont analysis. There is also the 5 step DuPont analysis. The additional parts are derived from the profit margin part. Instead of a single profit margin, we break up the profit margin component into three parts.
Return on Equity (ROE) = (Net Income/EBT) x (EBT/EBIT) x (EBIT/Sales) x (Sales/Assets) x (Assets/Equity)
The first three parts are the profit margin component. Notice how the terms can be cancelled out and Net Income/Sales stands out after cancellation. The ratio (Net Income/EBT) called as tax burden, this is also given by (1- Effective Tax Rate). The higher the tax expense, the lower will be this fraction. Remember this part will be less than 1. When using in the main equation denote this in decimal, not percentage. The second ratio (EBT/EBIT) called as interest burden. The higher the interest expense, the lower will be result of this fraction. Remember this part will also be less than 1 unless interest expense is nil. Lower this number, worse off the ROE will be. Denote this is also in decimal, not percentage. The third ratio (EBIT/Sales) called as Operating Profit margin.
There is an inter-relationship between the above three ratios in 5 step DuPont analysis. For example if debt is low in a company, interest burden might be low resulting in higher EBT/EBIT ratio; but the offset will take place in the financial leverage part of the equation (Assets/Equity). Lower debt means higher equity, thus lower financial leverage.
The DuPont analysis is an excellent method to determine the strengths and weaknesses of a company. A low or declining ROE is a signal that there may be a weakness. However, using the analysis you can better determine the source of weakness. Expressing the individual components rather than interpreting ROE itself may identify these weaknesses more readily.
There are some disadvantages in using ROE alone in financial statement analysis. ROE may be volatile due to the business’s normal sales cycles, or ROE may be lower or higher depending on the general profitability of the industry in which the company operates. A company may have an inflated ROE because of a very small value of book equity on its balance sheet, perhaps due to rapid growth or because the company has made large share repurchases. Likewise, the company may have taken on a large debt burden, increasing its leverage and potentially increasing ROE without increasing profitability or efficiency.