What is the DuPont Method for financial analysis?
DuPont analysis allows analysts to dissect a company, efficiently determine where the company is weak and strong and quickly know what areas of the business to look at (i.e., inventory management, debt structure, margins) for more answers.
The DuPont analysis looks uses both the income statement as well as the balance sheet to perform the examination.
The Dupont analysis looks at three main components of the ROE ratio.
Based on these three performances measures the model concludes that a company can raise its ROE by maintaining a high profit margin, increasing asset turnover, or leveraging assets more effectively.
Return on Equity
Defined in turns of Three other Key Ratios
The DuPont equation consists of three finacial ratios that are commonly calculated independantly, howver with the DuPont equation all three are multiplied togeteher in order to take into acount how well a firm uses the sales dollars it generates and the total returns of the shareholders money.
Return on Sales
Return on Sales is commonly called profit margin. It is measured simply as a percentage of net income to sales.This measure is how well a firm keeps some of its sales dollars in profit.
Return on sales, often called the operating profit margin, is a financial ratio that calculates how efficiently a company is at generating profits from its revenue. In other words, it measures a company’s performance by analyzing what percentage of total company revenues are actually converted into company profits.
Investors and creditors are interested in this efficiency ratio because it shows the percentage of money that the company actually makes on its revenues during a period. They can use this calculation to compare company performance from one period to the next or compare two different sized companies’ performance for a given period.
The formula for Return on Sales is:
Net Income ÷ Total Sales = Return on Sales
Total Asset Turnover.
The years sales are measured in comparison to the assets of the firm.
The total asset turnover ratio compares the sales of a company to its asset base. The ratio measures the ability of an organization to efficiently produce sales, and is typically used by third parties to evaluate the operations of a business. Ideally, a company with a high total asset turnover ratio can operate with fewer assets than a less efficient competitor, and so requires less debt and equity to operate. The result should be a comparatively greater return to its shareholders.
The formula for total asset turnover is:
Net Sales ÷ Total Assets = Total Asset Turnover
Equity Multiplier
The equity multiplier has to do with the notion of how well we use other peoples money to work for us rather than the firms own money. This notion of leverage come from the right side of the balance sheet where we typically find equity, debt and other liabilities.
The equity multiplier is a financial leverage ratio that measures the amount of a firm’s assets that are financed by its shareholders by comparing total assets with total shareholder’s equity. In other words, the equity multiplier shows the percentage of assets that are financed or owed by the shareholders. Conversely, this ratio also shows the level of debt financing is used to acquire assets and maintain operations.
Like all liquidity ratios and financial leverage ratios, the equity multiplier is an indication of company risk to creditors. Companies that rely too heavily on debt financing will have high debt service costs and will have to raise more cash flows in order to pay for their operations and obligations.
The formula for the Equity Multiplier is:
Total Assets ÷ Equity = Equity Multiplier