The Dupont Analysis or The Most Important Ratio

The Dupont Analysis or The Most Important Ratio

Bocar Moustapha Ba / May 28, 2020

I am a financial analyst, aspiring consultant in finance

Blogs/Articles

I have already published blog here in linkdIn on the following topics:

1)     The financial management in corporate finance

2)     The agency problem, Control of the corporation

3)     Result is sanity, Cash is king

4)     Financial modeling – An introduction

5)     Cash conversion cycle – Example of Amazon

6)     Standardized financial statement and ratio analysis

You’ll find the links at the end of this blog

The Dupont Identity – An introduction

Through my last sequence of blog (standardized financial statement and ratio analysis) I have discussed about the most common used financial ratio. Some of them are the ROE (return on equity) and ROA (return on assets).

The differences between these two profitability measures is a reflection of the use of debt financing, or financial leverage.

We’ll investigate the famous way of decomposing ROE into its component parts: profitability, productivity and financial leverage, or the Dupont identity.

The book I used as a source of this blog are:

Fundamentals of Corporate Finance (tenth edition). Ross Westerfield Jordan (Dr. Soc)

HOW FINANCE WORK: The HBR guide to thinking smart about the numbers. Author: MIHIR A. DESAI professor in Harvard. (2019)

Those books will help for any understanding about corporate finance, M&A and valuation. This book also covers all about capital budgeting, Cost of capital …etc. Highly Recommended!

A CLOSER LOOK AT ROE

Let’s definition of ROE:

Return on equity = Net income / Total equity

We could multiply this ratio by Assets/Assets without changing anything

Return on equity = (Net income / Total equity) * (Assets / Assets)

We can further decompose ROE by multiplying the top and bottom by total sales

Return on equity = (Sales / Sales) * (Net income / Total equity) * (Assets / Assets)

If we arrange things a bit, ROE look like this

Return on equity = (Net income / Sales) * (Sales / Assets) * (Assets / Total equity)

Return on equity =  Profit margin  *  Total asset turnover  *  Equity multiplier

Return on equity = Return on Assets * Equity multiplier

What we have now done is to partition ROA into its component parts, profit margin and total asset turnover. The last expression of the preceding equation is called the Dupont identity, after the DuPont Corporation, which popularized its use.

Profitability: The first important contributor to ROE is how profitable a company is. That goes back to the notion of profit margin.

Productivity: being profitable is important, but a ROE can be bolstered by productivity as well. It’s measured by the total asset turnover ratio.

Leverage: it’s also an important contributor to ROE. In this setting, we can measure leverage by dividing company’s assets by its shareholders’ equity.

Considering the DuPont identity, it appears that the ROE could be leveraged up by increasing the amount of debt in the firm. However, notice that increasing debt also increases interest expense, which reduces profit margins, which acts to reduces ROE.

The DuPont framework in action

The pieces of DuPont framework are usually different from one company to another depending on their market sector.

Food retailers’ margins is generally quite low, utmost 4%. In fact, profitability measures a company’s value addition. food retailers just don’t add much value. In contrast companies like Intel who makes its own computers, there are real value added. So it’s profitability is generally exceeding 20%.

But productivity (asset turnover) is the most important factor in achieving ROE for food retailers. Because the whole game is turning over those inventories as quickly as possible.

As we discussed before, leverage is a critical tool in finance. The banks are the one with higher leverage, but it’s also exceptional for its business.

Also, companies with stable demand and steady cash flow, generally sustain higher amounts of leverage. In contrast a business that is very high risk, like Intel, should not carry large amounts of leverage. Because leverage reflect the amount of business risk because it is unwise to pile financial risk on top of business risk.

General Motors, Example

General motors provide a good example of how DuPont analysis can be very useful and also illustrates why care must be taken in interpreting ROE value. In 1989, GM had a ROE of 12.1 percent. By 1993, its ROE had improved to 44.1 percent, a dramatic improvement. Even so GM’s profit margin declined from 3.4 to 1.8 percent, and ROA declined from 2.4 to 1.3 percent.

So this climbing is explained by the multiplier that went from 4.95 in 1989 to 33.62 in 1993.

In fact, what happened was that GM’s book equity value was almost wiped out overnight in 1992 by changes in the accounting treatment of pension case.

so, it’s about an improvement in financial performance at all

Extend DuPont Analysis

 Source : Fundamentals of Corporate finance , tenth edition

Earlier blog

Article 1: The financial management in corporate finance

https://www.dhirubhai.net/pulse/financial-management-corporate-finance-bocar-m-ba-cfp-fmva-

Article 2: The agency problem, Control of the corporation

https://www.dhirubhai.net/pulse/agency-problem-control-corporation-bocar-m-ba-cfp-fmva-

Article 3: Result is sanity, cash is king – Corporate finance

https://www.dhirubhai.net/pulse/result-sanity-cash-king-corporate-finance-bocar-m-ba-cfp-fmva-

Article 4: Financial modeling – An introduction

https://www.dhirubhai.net/pulse/financial-modeling-introduction-bocar-m-ba-cfp-fmva-

Article 5: Cash conversion cycle – Example of Amazon

https://www.dhirubhai.net/pulse/cash-king-part-2-example-amazon-bocar-m-ba-cfp-fmva-

Article 6: Standardized financial statement and ratio analysis

https://www.dhirubhai.net/pulse/standardized-financial-statement-ratio-analysis-ba-cfp-fmva-