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.
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).
