Du Pont Analysis Definition, Explanations and Templates
However by looking at the ROE just as an one single number analysts and investors are not really able to understand what makes the ROE such a good or poor indicator for a particular company.
As a single number ROE can lead analysts into a wrong conclusion without analyzing in more details the company performance related to the associated risk, profit margins and asset management ratios.
Du Pont analysis is an approach to financial analysis where the Return on Equity or ROE is analyzed by breaking it down to its three main parts.
The name Du Pont analysis is used because of the DuPont Corporation which started using this financial analysis method in 1920s.
How Du Pont Analysis Works?
Du pont analysis uses the following formula to analyze the ROE:
- ROE = Net Profit / Sales (This is the regular formula to calculate ROE in financial analysis)
- ROE = (Net Profit / Sales) x (Sales / Assets) x (Assets / Equity)
- ROE = Profit Margin x Asset Turnover x Equity Multiplier
The benefit of the Du Pont Analysis is the ability of the user to identify and calculate the three components of the Return on Equity. With the formula described above financial analysts can identify what drives the performance of a certain level of ROE. Is the ROE strong or poor mainly because of the profit margins or assets turnover or equity.
Compared to the regular or short ROE formula the Du Pont formula gives a thorough description of the way ROE has been developed. In addition it gives business and financial analysts an opportunity to benchmark and compare each of the three individual components with another company by comparing the margins, assets and equity financial ratios.
By using this same approach to financial analysis you can analyze any organization. There are industries where companies will perform extremely good or poor on some of these three components. For example there are industries with traditionally high and low profit margins.
Retail industry with low profit margins will have to perform especially well in the other two components of Du Pont in order to score with a good ROE compared to another industry.
On the other hand, IT, entertainment and R&D driven industries will have a high profit margin but the asset turnover for example is going to be lower than in the retail business. While retailers have low margins they have a high asset turnover.
This example shows how Du Pont analysis can help you break down the return on equity calculation in a detailed analysis of three individual components and understand the real picture of the financial situation of the company.
As a conclusion, Du Pont analysis is a performance measurement method also known as Du Pont Identity or Du Pont Ratio. With this financial analysis methodology we can measure the three components which together make the return on equity: profitability, asset management and financial leverage.