Understanding DuPont Analysis: Deconstructing a company’s financial performance

The skill of the driver : The split second reactions that separate the great drivers from the good

The Race Car’s design : How effectively the team utilises the car’s engine and its aerodynamics to cover ground on the racetrack

The Pit stop strategy : Effective usage provides fresher tyres and fuel to gain competitive edge while excessive pit stops harm the overall race performance

These factors help the management gain deeper insights into what exactly is impacting the team’s results and thus, helps them make informed strategic decisions.

Now, when we talk about a for-profit company, we commonly use two profitability measures : Return on Assets (ROA) or Return on Equity (ROE) to describe its results. To find the factors ‘driving’ these results, we can use DuPont Analysis (a.k.a. DuPont Framework), a powerful financial analysis tool which we discuss in this article.

Basics of the Framework:

Named after the chemical company “DuPont”, which first introduced it in the 1920s, this framework aims to break down ROE into its component parts in the following manner :

ROE =

Using simple algebra, the above equation can be written as :

ROE =

which can be interpreted as:

ROE = [1]

If we decompose the above equation further, we can express ROE as:

ROE =

which can be interpreted as:

ROE = [2]

Where,

Net Profit Margin (NPM): Measure of the company’s ability to convert revenues into profits. Analogous to the skill of the driver – Just as a skilled motorsport driver can maximize the racecar’s performance on the track, a company with a high NPM is proficient at converting its revenue into profits

Total Asset Turnover: Evaluates how efficiently a company utilizes its assets to generate sales. Similar to a racecar’s design – A high asset turnover indicates that the company is using its assets effectively to generate revenue, just as an effectively designed racecar can cover more ground in less time.

Financial Leverage : Examines the extent to which a company relies on debt to finance its operations. Comparable to the team’s pit stop strategy – When managed well, leverage can boost returns, but too much of it can lead to financial troubles, just as excessive pit stops can lead to inefficiency and potentially harm the overall race performance.

Equation 2 forms the basis of the DuPont framework and is often known as a 3 step DuPont Analysis. Practitioners often decompose this equation further by breaking down the Net profit margin part into its own separate components to reflect the impact of taxes, interest and operating profitability on the ROE. This is done as shown below:

ROE =

=

Where,

EBT is Earnings before taxes

EBIT is Earnings before Interest and taxes

So, the above ROE equation can be interpreted as:

ROE = [3]

The above equation is known as the 5-step DuPont Analysis.

Applications

During financial decision-making, this framework is usually used for:

Identifying a company’s strengths and weaknesses: If shareholders are disappointed with the low ROE levels of a business, its managers can use this framework to find its weakness and take corrective action.

Comparable analysis: Within an industry, breaking down the ROE into its components helps Investors identify where a company stands relative to its rivals. It also helps managers benchmark their performance and find areas that need improvements.

Evaluating Historical performance: By analyzing the changes in these components over time, analysts can track the evolution of a company’s ROE and gain insights into the effectiveness of management’s decisions and initiatives. Doing this activity for an industry can help them identify the headwinds and the tailwinds that the industry might be facing.

Example

Let us say we are analysing the Utility industry and find two investable companies. Both have the same ROE of 20%. We would like to know the more promising of the two. Using their accounting statements, we gather the following data:

In Company A’s case, costs are lower which are highlighted by the higher margins but the high leverage is worrisome and can make the company face a liquidity crisis

Company B on the other hand, seems less risky given its lower financial leverage and is more efficient in generating sales from its assets given its higher asset turnover

Although further research is still required, the above observations provide us with an initial guidance, which can help us use a more focused approach.

Disadvantages

Like every framework, this also has certain disadvantages:

The model is backward-looking as it relies on historical data, which may not predict future performance accurately

Information used in this analysis is derived from the company itself so there is always the chance of manipulated numbers, leading to incorrect observations.

Although this framework simplifies the complexities of a business into three components, in reality, various other factors like overall economic conditions, industry specific regulations and cyclicality can influence a company’s financial performance and its ratios.

Concluding remarks

While Du-Pont Analysis has its limitations and challenges, it does provide us with a useful framework

which can help us gain a more profound understanding of what is driving a company’s profitability, how it stacks up against competition and how it has transformed over the years. Probably this is why it is an essential framework in the financial analysis domain. The Wall Street School, through its flagship “Financial Modelling and Valuations program” and the “Stock Market Training Program“ covers this framework extensively along with other useful financial analysis and modelling tools which are essential to learn for candidates who want to make a career in finance and/or want to become better investors.