DuPont Analysis

While making my way through the Chartered Financial Analysis (CFA) level 1 curriculum in the Financial Reporting and Analysis (FRA) section, I encountered one of the most important tools in financial statement analysis--the DuPont Analysis. I’d like to take a moment to explain not only the process for completing this analysis but also breakdown the potential usefulness of it.

We will begin the conversation with the ratio known as return on equity or ROE. This is a measure of the total return based on the amount of book equity the firm has in its capital structure. Return is simply net income as this is the allocation of earnings that equity investors have title to. The simplest form of the DuPont analysis breaks the ROE calculation into two portions, the first is return on assets (ROA) and the second is the financial leverage ratio. ROA can be viewed as a measure of how efficiently the firm is utilizing the assets they have while the financial leverage ratio (sometime called the equity multiplier) is the amount of debt in proportion to the amount of equity a firm has within this capital structure.

 This shows us that changes in ROE can be linked to either a change in the return on assets or the amount of leverage used within the business. While this is a base line equation, we can continue to break this down further. We can next break the ROA into two separate factors, net profit margin and asset turnover.

In doing this breakout, we are not able to determine that changes in ROE can be attributed to changes in net margins, asset efficiency (asset turnovers) and use of leverage.

The last step to breaking out the DuPont equation is taking a look at net profit margin. We can view net profit margin as a function thee key areas, the first of which is the earnings before interest and taxes (EBIT) margin, sometime referred to as the operation margin. This is the income the firm earned from normal operations without consideration of capital structure. The second factor is the interest burden which takes earnings before taxes (after interest) and compares it to EBIT. This will indicate how much of the firm’s earnings are being used to service the debt within the capital structure. The last factor is the tax burden which shows us the firm’s tax rate. 

This allows us to analyses changes in the net profit margin of the firm based on operating changes (EBIT margin) changes in debt service costs (interest burden) and tax rates. Finally, we can combine all these calculations to end with the five step DuPont analysis of ROE.

Apply simply cross multiplication and this equation breaks down to net income over equity, or ROE. As analyst, we are able to look at ROE of a firm and determine what factors have helped the firm achieve their given ROE. More importantly, we can analyses time-series data and determine what is causing changes in ROE form one period to another. For example, if a firm has a 10% increase in ROE year over year and you apply the DuPont analysis to determine that this change is caused by an increase in the use of leverage it will be much less favorable than an identical firm which had the same 10% increase due to improved efficiency or margins (asset turnover or EBIT margin).