Contents
What’s it: DuPont analysis is an approach to breaking down the ratio of return on equity (ROE) into several specific ratios. It helps us know why a company’s ROE is superior (inferior) to competitors. If we compare the components from year to year, we will also know why the return on equity ratio has gone up or down.
Why is DuPont analysis important?
Breaking down ROE into more specific ratios is useful for several reasons. First, it facilitates meaningful evaluation by breaking down ROE into several financial metrics to measure company performance.
Second, it helps in determining the reasons why a company’s ROE changes over time. And, also, when we compare it with competitors, we will understand why companies are superior in providing returns to their shareholders compared to peers.
Third, analysis helps management to focus more on managing the company’s operations and finances. As a result, they know what they should be doing to increase ROE and provide high returns to shareholders.
How does DuPont analysis work? How to interpret it?
DuPont analysis breaks down ROE into several financial metrics. There are three approaches to analysis, namely:
- Two-step DuPont decomposition
- Three-step DuPont decomposition
- Five-step DuPont decomposition
Before going any further, let’s briefly discuss ROE. It’s a metric to measure the rate of return to shareholders based on the net income earned. To get it, we divide net income by total shareholder equity. Here is the ROE formula:
- ROE = Net income / Total equity
ROE measures how well a company uses equity capital to generate profits. It is a factor in valuing the company’s stock price.
In addition, analysts also use it to measure how successful the company’s performance and executives manage the business. Usually, their compensation is related to ROE performance. For this reason, executives will try to avoid a sharp decline in ROE.
Two-stage DuPont decomposition
Under a two-stage decomposition, ROE is a function of the return on assets (ROA) and the company’s leverage level. Here is the formula:
- ROE = ROA x Financial leverage ratio
Where:
- ROA = Net income / Total assets
- Financial leverage ratio = Total assets / Total equity
The formula above shows us two ways to increase ROE. First, the company can do this by increasing its return on assets (ROA). Second, the company uses more leverage (debt) to finance its operations.
ROA gives us an idea of how efficiently the company generates profits using its assets. The higher the ROA, the better the company is at making a profit.
The financial leverage ratio measures solvency and tells us how much a company uses debt to finance its operations. The higher the ratio, the greater the debt.
In general, the company’s capital comes from equity and debt. If equity has implications for share ownership in the company, debt has implications for routine cash outflows to pay interest.
When a company has high debt in its capital structure (high financial leverage), it leads to a higher return on equity. The higher debt causes the company to pay higher interest. And interest expense is tax-deductible.
But, please remember, these implications for ROE apply only if borrowing costs are lower than marginal returns. And, if a company’s borrowing costs exceed its marginal return, taking on more debt will depress ROA as well as ROE.
Three-step DuPont decomposition
Under this approach, we break down ROE into three financial ratios as follows:
- ROE = Net profit margin x Asset turnover ratio x Financial leverage ratio
Where:
- Net profit margin = Net profit / Revenue
- Asset turnover ratio = Revenue / Total Assets
- Financial leverage ratio = Total assets / Total equity
Net profit margin, or net income margin, is a metric to measure profitability. It tells us how well the company is converting revenue into net income.
To calculate net income, we include all revenues and expenses, including:
- Cost of goods sold
- Selling expenses
- General and administrative expenses
- Depreciation expense
- Net non-operating expenses (income) such as interest, taxes, and exchange rate translation losses (gains)
When the net profit margin increases, it increases ROE. In this case, the company brings more profit from each sale.
The asset turnover ratio measures how efficient the company is in managing its assets. Specifically, it tells us how much revenue the company generates using its assets.
When the asset turnover ratio increases, the company manages to book more sales using its assets. Thus, it will result in higher ROE.
Five-step DuPont decomposition
Under this decomposition, ROE is a function of the following five indicators:
- ROE = Tax burden x Interest burden x EBIT margin x Asset turnover x Financial leverage ratio
Where:
- Tax burden = Net income / EBT
- Interest burden = EBT / EBIT
- EBIT margin = EBIT / Revenue
- Asset turnover = Revenue / Total assets
- Financial leverage ratio = Total assets / Total equity
EBT stands for earnings before tax. We also often call it pretax income or pretax profit. We can find it on the income statement, just above the tax expense account.
Meanwhile, EBIT stands for earnings before interest and tax. It’s usually not on the income statement, and we have to calculate it manually.
We can use two approaches for calculating EBIT. First, we can start with revenue. In this case, the formula is:
- EBIT = Revenue – Cost of goods sold – Selling, general and administrative expenses + Other non-interest income (expense)
Some people exclude other non-interest income (expense) in calculating EBIT. So, in this case, EBIT will be the same as operating profit, which is the difference between operating income and operating expenses. Operating expenses consist of the cost of goods sold and selling, general and administrative expenses.
Second, we can calculate EBIT from net income and add back interest and taxes. The formula is as follows:
- EBIT = Net income + Interest + Tax
Alright, let’s go over the items under the five-stage DuPont decomposition.
Tax burden measures the effect of taxes on company profits. It tells us the remaining profit after the company pays taxes and is equal to 1 minus the average tax rate. So, it is equal to 1 if the tax is zero.
A high tax burden increases net income because the average tax rate decreases, contributing to a higher ROE. A reduction in tax rates may occur because the company generates more revenue in a lower tax jurisdiction. Or it is because of a new legislative policy from the government.
Meanwhile, when the tax burden ratio decreases, the average tax rate increases. As a result, it lowers net income and reduces ROE.
The interest burden tells us how the interest expense affects ROE. A high-interest expense reduces net income, the interest burden ratio falls and lowers ROE. The interest burden will be equal to 1 if the company has no debt.
EBIT margin is a metric to measure the company’s operating profitability. A higher EBIT margin means better converting income into profit after covering all non-interest and tax expenses. As a result, it increases the company’s ROE.
As I mentioned earlier, we may prefer to use operational numbers and exclude non-operational components. It is more meaningful in showing us how profitable the company’s operations are. In this case, the EBIT margin will equal the operating profit margin.
Non-operating components are unstable and change from year to year because they don’t come from its core business. Also, its value is usually less significant.
Pros of using the DuPont analysis
There are several reasons for using DuPont analysis.
First, for management, it is useful to focus on improving ROE. DuPont analysis describes in detail the reasons why ROE changes.
The analysis breaks it down into more specific financial ratios. Thus, management has deeper insight into what they need to do, whether to increase profit margins, improve asset utilization, or increase financial leverage.
Second, decomposition helps answer why a firm has superior returns compared to its competitors. Again, we come to know where the company’s excellence comes from through its components.
Third, DuPont analysis helps to assess whether management strategies to increase ROE are appropriate or not. For example, analysts usually appreciate if management devises strategies to improve operational efficiency or asset utilization.
Conversely, it is usually underappreciated if management is simply trying to increase ROE through increased financial leverage. Increasing leverage will only result in higher interest expense and financial risk, especially if the company already has high enough debt.
Cons of using the DuPont analysis
First, there is no ideal standard for each component in the DuPont decomposition. They vary between companies, depending on management’s business strategy.
Then, they also depend on the industry in which the company operates. Therefore, they will vary from industry to industry. So, it is irrelevant if we use it to compare companies with different industries. Long story short, DuPont analysis is useful when we compare companies in the same industry.
Second, financial figures are often vulnerable to manipulation. Management has an interest in recording high ROE because it has an impact on the compensation they get.
For example, they may hide nonconformities and practice earnings management. One way is through earning smoothing, in which management manipulates revenue and expense recognition between reporting periods. It aims to reduce fluctuations in net income. That way, they can secure compensation over time.
