If you’re trying to pinpoint which factors are driving your company’s performance, or if you’re trying to persuade investors that your company is worth their attention, the DuPont analysis is one of the most powerful tools at your disposal.
However, even though it’s been around for a century, the DuPont system of analysis may be unfamiliar or obscure to many business owners, and even to some financial analysts who are used to working with other methods of measuring profitability.
The DuPont analysis formula goes one step beyond other popular profitability measures by taking into account not only how efficiently your company is utilizing investor equity, but what underlying factors are driving how well you use equity.
This can help you pinpoint whether your sales, asset utilization, debt management or other variables are driving your performance, and which of these factors you’d need to address to improve your results. This can benefit you internally by improving your company’s financial management, as well as helping you make your company more attractive to investors.
Here’s an in-depth look at the DuPont framework of analysis, how it can benefit your business, how you use it and how you can apply it to improve your performance or attract investors.
What Is DuPont Analysis?
The DuPont analysis equation, also known as the DuPont identity, was invented in 1912 by DuPont salesman Donaldson Brown, who had an electrical engineering background and had been tasked by company treasurer John Raskob with using his knowledge of statistical formulas to evaluate DuPont’s sprawling business interests.
Brown came up with an equation that went a step beyond other profitability measures by breaking down how a company’s utilization of equity is affected by underlying variables such as sales volume, asset utilization and debt utilization.
Since Brown’s time, the extended DuPont analysis has expanded his original equation to further isolate how operational efficiency and interest expenses affect performance.
The DuPont formula builds on a traditional financial ratio known as return on equity (ROE).
Return on Equity Defined
While ROE is a useful measure, it has some limitations that can lead to misleading interpretations.
For example, the ROE ratio can increase if a company takes on more debt by borrowing more loans, which reduces shareholder equity and thereby decreases the denominator in the ratio. Shareholders may misinterpret this as an increase in sales or profitability, when in fact it simply means the company has increased the proportion of its financing that is coming from loans rather than investors.
The Three- and Five-Step DuPont Models
To avoid such misinterpretations, the method invented by DuPont factors in what underlying variables are affecting ROE. Brown’s original method, known as the “Three-step DuPont Model,” breaks ROE down into three contributing factors that affect ROE:
- Net profit margin (NPM): how efficiently a company’s operations generate profits in proportion to expenses
- Total asset turnover (TAT): how efficiently a company generates profits in proportion to its assets
- Financial leverage (FL): how efficiently a company manages its assets in relation to the amount of equity investors contribute
Multiplying these three factors cancels out the units in the numerators and denominators, yielding a raw percentage that represents ROE.
This formula separates how operational efficiency, asset efficiency and efficient use of equity contribute to ROE. However, because all three variables are multiplied together, operational factors are not sharply separated from financing factors such as loans and equity, which can blur how these contribute to the total picture.
To make this clearer, the basic DuPont formula can be expanded by breaking net profit margin down into a product of three ratios representing:
- Pre-interest pretax profit margin: how much of its earnings before interest and taxes (EBIT) a company keeps as profit from its sales
- Interest burden: how much EBIT goes towards repaying loan interest
- Tax efficiency: the effect of taxes in relation to EBIT and interest
When these additional ratios are integrated into the original three-step equation, it yields a total of five ratios being multiplied together, so this is called the “Five-step DuPont Model.” As in the three-step version, the units in the five-step version cancel out, leaving ROE. The additional steps highlight how loan interest and tax rates affect ROE.
Why Do a DuPont Analysis?
DuPont analysis interpretation is useful for several major reasons:
- You can use the DuPont analysis formula to identify how specific variables are affecting your use of shareholder equity and your overall profitability. For instance, you might identify how much of your profits are going towards repaying interest.
- You can then use this information to optimize your financial management by taking steps such as increasing sales activity or lowering expenses. For instance, if you’ve determined that a relatively large percent of your revenue is going towards repaying interest, you might try to refinance your business loan.
- You can also use the results of DuPont analysis to showcase your efficient use of equity to investors or to improve factors where you could improve your efficiency to impress investors.
When using the DuPont method, it’s important to be aware that it may apply differently to different industries. Some industries, such as fashion retail, depend heavily on high profit margins for profitability. So in this case, a DuPont analysis might be geared towards identifying how sales volume can be increased without shrinking profit margins.
In contrast, a fast food chain might have low profit margins with high asset turnover rates. Other industries, such as sellers of heavy machinery, might have very high profit margins offsetting low sales volume.
In some sectors such as investment banking, the business model is unique enough that DuPont analysis requires considerable modification before it can be meaningfully applied.
An experienced financial analyst can help you apply the DuPont method to your industry.
How Do You Do a DuPont Analysis?
DuPont analysis explained in non-mathematical terms helps you understand what it is, but to actually do it, you need to know the DuPont analysis equation. There are two different equations for the three-step and five-step versions.
The Three-Step Equation
In a three-step analysis, you multiply your net profit margin ratio by your total asset turnover ratio by your financial leverage ratio (called your equity multiplier) to get your ROE. This is equivalent to multiplying the ratio of net income over sales revenue times the ratio of sales revenue over average total assets times the ratio of average total assets over average shareholders’ equity.
The Five-Step Equation
In a five-step analysis, you multiply the ratio of net income over pretax income times the ratio of pretax income over earnings before interest and taxes (EBIT) times the ratio of EBIT over sales revenue times the ratio of sales revenue over average total assets times the ratio of average total assets over average shareholders’ equity.
To illustrate a simple three-step DuPont analysis example, consider two retailers with the same ROE but different underlying variables.
Retailer #2 has a profit margin of 15 percent, a total asset turnover of 6.0, and a financial leverage factor of .50.
Both retailers have the same ROE of 45 percent, but Retailer #1 has a high profit margin with a low rate of sales turnover, whereas Retailer #2 has a lower profit margin with a higher sales turnover rate. This example illustrates why a DuPont breakdown can be more informative than a simple ROE.
How Do You Apply a DuPont Analysis?
To apply the DuPont analysis equation to a practical situation, you should:
Decide what your goals are and which variables you want to highlight. This will help you decide whether to use a three-step or five-step approach.
For instance, if you’re going to isolate how loan interest payments are affecting your profitability so you can decide whether to refinance your loan, you will want to use the five-step approach.
After deciding which formula to use, you can then import the relevant data from your income and balance statements into the DuPont formula. The most efficient way to do this is to automate the process by syncing your accounting software with a business intelligence dashboard that displays your DuPont variables at a glance as key performance indicators. Your accountant or financial analyst can work with your IT support to set this up.
Once you have your data, the next step is to optimize your performance to achieve your desired goals. Depending on your goals, this may require you to increase your sales activity, cut your operational costs, change your financing strategy or change your tax strategy, to name a few possibilities.
Using a DuPont analysis to improve your performance in one of these areas can be used to improve your company’s internal financial management, or it can be used to enhance your company’s image in the eyes of investors or potential investors.
Modeling Your Way to Enhanced Profitability
A DuPont analysis analyzes the factors underlying how efficiently a company generates profit from shareholder equity.
There are two types of DuPont formulas: a three-step version which focuses on operational efficiency, asset efficiency and efficiency use of equity; and a five-step version which expands the original equation to consider how interest and tax rates affect profitability. Both types of analysis can be useful for analyzing where your company can optimize its financial management or for making adjustments to attract investors.
Whether you should do a three-step or five-step analysis depends on which factors you want to highlight. Your accountant or financial analyst can help your IT team set up automated tracking of your DuPont factors so you can monitor them easily and put them to practical use.