Break down Return on Equity (ROE) into its core drivers: profitability, efficiency, and leverage.
Net Profit Margin (NPM):
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Total Asset Turnover (TAT):
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Financial Leverage (FL):
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Return on Equity (ROE):
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DuPont Analysis formula refers to a methodology that uses the return on equity (ROE) ratio of a business, and breaks it down into three other financial ratios in order to pinpoint the drivers of ROE. The ratio is used to find out whether a company’s ROE is high because it’s highly profitable, highly efficient, or highly leveraged.
By using the DuPont Analysis formula, investors can understand how ROE of a company is being influenced by its net profit margin (profitability), total asset turnover (efficiency), and financial leverage (risk).
If a company has Sales of $1,000,000, Net Income of $120,000, Total Assets of $500,000, and Total Equity of $250,000, the DuPont Analysis would be:
Use the following rules of thumb as guidelines to help in the interpretation of DuPont Analysis. However, there is no definitive formula for a good and healthy score and you should always compare the ratios against industry peers and historical performance.
High Net Profit Margin: Good. The company is able to keep more of each dollar of sales as profit, which will contribute to a higher ROE.
High Total Asset Turnover: Good. The company is using its assets efficiently to generate sales, which will also contribute to a higher ROE.
High Financial Leverage: Good, but not too high. The company is using more debt compared to equity, which can increase ROE, but it also increases financial risk to the company.
High ROE primarily driven by high leverage: Bad. A high ROE is better if it is driven by high profitability and efficient use of assets, rather than by excessive use of debt.
There is no one-size-fits-all answer to this question, as a good ROE depends on the industry and the company’s risk profile. However, as a general rule of thumb, a good ROE is typically above the industry average, but it is important to make sure that a high ROE is not being driven by high leverage, which can increase financial risk.
Net profit margin is the percentage of revenue that remains as profit after all expenses have been deducted. It is calculated as Net Income divided by Sales.
Total asset turnover measures how efficiently a company uses its assets to generate sales. It is calculated as Sales divided by Total Assets.
Financial leverage measures how much of a company’s assets are financed by equity versus debt. It is calculated as Total Assets divided by Total Equity.
