Explaining DuPont Analysis
DuPont Corporation created a unique performance measurement system for its investment initiatives in the 1970s relative to other businesses.
DuPont’s technique defines ROE by its components.
DuPont’s multi-faceted ROE calculation better detects financial leverage than a simpler one.
DuPont research shows three key ROE factors:
Operating efficiency (profit margin)
Total asset turnover measures asset utilization efficiency.
Equity multiplier-measured financial leverage
ROE can be broken into three sections to show investors how well a company uses equity.
The Original DuPont Analysis
Financial accounting depreciation procedures may artificially lower ROEs in an asset’s initial year of operation, causing new asset avoidance.
DuPont analysis helps identify underperforming business units if ROE is low.
Thus, DuPont Corporation gained importance after adopting a new strategy.
DuPont analysis is now a prominent ROE calculation method.
DuPont research holds that ROE using net book value discourages riskier investments since it underestimates return for the first several years.
DuPont analytical calculations address this.
ROE can be broken down into profit margin, asset turnover, and leverage components to show investors how well a company uses equity.
Poorly performing components lower the overall figure.
Multiply the profit margin by assets to obtain ROE using DuPont approach. The DuPont model’s financial components are listed below.
Profit margin x Asset turnover x Equity multiplier equals ROE
DuPont Analysis Use
The profit margin shows how well management runs the company and controls costs.
Asset turnover gauges the company’s sales per dollar of assets.
The equity multiplier measures a company’s leverage by calculating stockholder financing per dollar of assets.
DuPont analysis can forecast Return On Net Operating Assets fluctuations.
As long as industry groups use the same measure, it enables comparison.
Enterprises are analyzed by examining performance measure linkages.
DuPont study identifies profit-boosting elements.
Identifying these characteristics helps increase business efficiency.
Pros and Cons of DuPont Analysis
Many benefits come with DuPont analysis:
First, DuPont analysis lets investors compare alternative stock investments’ ROEs.
The influence of operating efficiency, asset utilization efficiency, and financial leverage on ROE is determined.
Second, DuPont analysis helps portfolio managers understand stock ROE drivers.
Finally, DuPont analysis measures investment portfolios.
Using this statistic alongside other income statement items like return on investment, cash flow as a percentage of sales, or others will yield great analytical findings.
DuPont analysis had flaws. These are:
It is a short-term pre-tax measurement.
It does not affect capital cost, time value of money, or value.
Good ROCE targets are hard to set.
Gross asset value instead of net value violates principles and standards-based accounting.
DuPont Analysis ROCE and Other Ratios Calculation
Table following shows data used to determine all DuPont analysis ratios. It compares TVS and Bajaj across three years.
Numerous analytical points apply to the table above.
1. TVS’s low operational profit (PBIT) and high capital employed diminish its ROCE. This has been TVS’s expansion strategy for three years. Thus, it cost more.
Thus, TVS’s non-trade investment is minimal compared to other competitors, especially long-standing ones.
2. TVS has a lower PBIT/Sales due to its industry-leading EXP/Sales.
3. TVS has higher sales/TA than the industry average due to lower total and current assets.
4. TVS also has higher Sales/CA than Bajaj due to lower Other CA, Loans, and ADV levels.
5. TVS has little capital employed since it has a low net worth and has raised less long-term loans than Bajaj.
DuPont analysis is increasingly utilized to analyze performance and increase ROE.
By accurately forecasting return on investment, using gross book value instead of net book value might stimulate investment in new, potentially hazardous companies.
DuPont analysis breaks return on net operating assets (RNOA) into profit margin and asset turnover, which is a substantial benefit. Both depend on industry membership.
This analysis’s useful components enable data-adjusted industry comparisons, which forecast RNOA changes.
This approach, together with investor or market strength ratios, can help investors make excellent portfolio decisions.
Example of DuPont Analysis
Company Ltd recorded 2019-20 data:
Net sales $9,600,000.
$6,500,000 net assets
Gross assets $7M
Equity ($10 per share) 5,000,000
Required: Calculate these:
Efficiency of operation
Use of assets efficiently
Financial leverage under:
The DuPont analysis
Compare results and discuss from an investor’s perspective.
Solution: Net assets turnover is evaluated in the traditional technique.
The asset utilization efficiency under gross total assets is 1.371 and under net total assets is 1.476. These findings demonstrate that gross book value eliminates the motivation to avoid new asset investments.
Operating activity, asset utilisation, and financial leverage are ignored in ROE calculated by EBIT divided by Total Stockholders Equity. However, DuPont study clearly indicates ROE component roles.