The DuPont analysis is a financial performance framework which aim is to break down the different financial metrics that affect the return on equity (ROE) to understand what is driving it. Thus, the DuPont Analysis allows having a better understanding of the primary drivers of the return on equity.
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What is the return on equity?
One of the most used ratios in finance is the ROE (return on equity). This ratio is the relationship between the net income, which is the bottom line of the income statement; and the shareholders’ equity (capital endowed by shareholders).
This ratio explains what the level of return generated for each dollar invested. For example, a 20% ROE means that for each dollar invested into the business 20 cents are earnings.
Keep in mind that returns are not dividends. In other words, the profits generated by the firm might not be automatically distributed to shareholders. Indeed, the part of profits distributed to shareholders is called dividend.
Often a company that produces high returns also distributes higher dividends compared to non-profitable companies (true in most cases). In short, a company that can provide a high ROE usually is also well perceived by investors.
Why the return on equity might be biased
There is a drawback to this ratio tough. The ROE usually increases for three reasons:
- The net income increased,
- The shareholders’ equity decreased or
- Both conditions are met.
While the first and the third are in most cases a good sign, the other condition (the shareholder’s equity decreased) it isn’t always a good sign:
In fact, an increase in net income is usually due to improved profitability or better efficiency in the business operations. Instead, a decrease in shareholders’ equity it is generally associated with higher leverage, which can be bad for the company in the long run.
Therefore the objective here is to see how the ROE evolved over time. Did it increase from 2014? If so, why?
The financial ratios part of the DuPont analysis
To perform the DuPont analysis, we need to compute three ratios:
Net Margin ratio
The net margin is a financial management ratio given by the net income divided by the net sales. In short, this measure tells us of the total revenues what percentage goes toward profits for the organization.
A high net margin is a good sign, and usually, this happens for two main reasons. Either the firm can charge a higher price for its products and services. Or the firm can sell a high quantity of them. In both cases, profitability improves.
On the other hand, when a firm can reduce its overall expenses, its profitability improves too. For instance, the company may be able to get a better price for the raw materials, due to its good relationship with suppliers. Therefore, through the net margin, we will check the level of profitability of the firm.
Asset Turnover ratio
The asset turnover is a financial management ratio that tells you whether a company is able to generate revenues from its assets. That is simply given by dividing the total revenues over the total assets. In short, it shows whether the company is using those assets to grow the revenues. Thus, the business.
Therefore, the higher the ratio and the better in terms of efficiency of the way the assets are managed. I expect that with the increase in the value of the assets, also the revenues will grow.
For instance, Apple opens new retail stores (increased assets) because it wants to expand its revenue growth. Furthermore, we can expect that opening new retail stores, will positively impact the revenues of the firm. If this condition is met the company’s assets are well managed and the asset turnover will increase over time.
This ratio will be expressed as a number and will tell us how much revenues are generated for each dollar invested in assets. For instance, an asset turnover of 0.50, means that for each dollar invested in the asset are produced 50 cents in revenues.
Financial Leverage ratio
This financial management ratio tells us the level of leverage of an organization. It is given by the assets over the equity. Thus, it shows the so-called equity multiplier or what mix the company is using in terms of equity and debt to finance its assets.
In general, the more a company pumps debt the more it might become risky. In fact, while using financial leverage might be a good way to finance the growth of an organization. There is a level after which that debt can become a burden!
The higher the number, the more debt has been pumped into the company, and the riskier the company may become over time. Usually, leverage itself is not a bad thing. Actually, in many circumstances using debt is less expensive than using capital.
For instance, if you try to buy a house, which costs $100K, you can put 100% capital or use 50% capital and borrow 50% from the bank. Assuming you will sell the house in one year at $120K your ROI (return on investment) will considerably increase by using leverage.
Instead, f you sell the house for $120K after putting $100K of capital, your ROI will be 20%, given by the profit of the sale (120K – 100K) over the initial capital invested (100K).
In the second scenario, you still sell the house for $120K, but in this case, your ROI before interest and taxes will be 40%. In short, you used leverage (debt) to double your ROI, and this didn’t bring any downside. If financial leverage is not necessarily a bad thing, it starts to be dangerous when interest payments rise steeply and swipe your profits away.
Apple Inc. DuPont analysis example
From an analysis, I performed about Apple Inc you can see how the ROE increased substantially (from 33% to 46%). If we use the DuPont framework you can see how it mainly increased due to leverage and profitability. In short, Apple Inc. was able to improve its revenues but substantially increasing its debt burden in those years.
How to perform a DuPont analysis in excel
In this video, I show you how to perform a DuPont Analysis in Excel, from scratch!
The post What Is a DuPont Analysis? How to Perform a DuPont Analysis from Scratch appeared first on FourWeekMBA.
