The Return on Asset and Return on Equity are one of the most important considerations an investor takes while making an investment decision. It gives an insight into how well a company is using its assets to generate revenue and determines the value it creates for its shareholders and investors. However, these ratios still do not provide the whole picture. It is important to break down the components of ROA and ROE, and understand each of their current positions so that an investor can make a more informed decision. Without breaking down the ROE, an investor can be duped into believing that a company is a good investment when, in reality, it's not. Hence, to break down the ROE components and understand each of their roles and effect on the ROE ratio, a DuPont Analysis is performed.
Understanding DuPont Analysis
DuPont analysis is an equation that shows that a company's Return on Equity and Return on Assets can be broken down into its components and can be represented as a product of multiple figures. The DuPont analysis comes from DuPont Corporations, which began using this method in the 1920s, to break down the components of ROE. It shows the causes of shifts in the number.
The DuPont analysis is a framework for analyzing the fundamental performance of a business and is used in the present to compare the operational efficiency of two similar firms. It is a technique that is used to decompose the different drivers of the return on assets and return on equity ratios.
The relation between Return on Assets and DuPont Analysis
The DuPont analysis method breaks various components of business performance indicators into smaller parts. This decomposition of performance metrics helps business owners and investors understand if all these smaller components are performing with their fullest efficiencies. Return on Assets measures a company's profitability as relative to its total assets. Assessing the individual performances of net profits and assets helps understand the company's strengths and weaknesses. It helps business owners improve their performance and helps investors make a more informed decision.
The two components of the Return on Asset ratios are net profits(income) and assets.
ROA = Net Income (profit)/ Total Assets
Net profit margin:
Profit margin is one of the most important factors in breaking down ROA through the DuPont Analysis. This financial figure depicts how much revenue or income, a business can generate after it pays for its production costs, including raw materials, employee wages, and product advertising. Calculating net profit margin requires a business to add its net income to its interest income and then divide it by gross revenue. Net income is the total earnings of a business after it pays off all its expenses, while interest income is money that is earned on cash temporarily held by the business in investment accounts or deposit.
Profit Margin = Net Income / Sales
Asset Turnover Ratio:
Asset Turnover Ratio is the measure of how much a company generates with every rupee it holds in its assets. DuPont analysis calculated this ratio requires a business to divide gross revenue by its average total assets over a given period, which is usually 12 months. Gross revenue represents total earnings before the business pays off its expenses and taxes. Average total assets are the average value of company assets obtained by dividing the beginning and end total values of business assets.
Asset Turnover Ratio = Sales / Average total assets
Calculating Return on Asset through DuPont Analysis
In DuPont analysis, these two performance metrics- net profit and asset turnover ratios are combined to figure out the Return on Asset Ratio of the company.
Return on Asset through DuPont analysis
ROA = Net Profit Margin X Asset Turnover Ratio
Let us consider the following example,
Company ABC Ltd has sales of Rs 1000, and total average assets and liabilities are Rs 500 each. The operating profits are Rs 86. The company's total assets include Rs 200 as debt and 300 as equity, with an interest rate of 6%.
This makes the net income as Rs 74.
Considering the DuPont Analysis,
ROA of ABC Ltd = 74/1000 * 1000/500
= 74/500 or Net Income/ Total Assets
To generate a higher rate of return on assets, a business is required to increase its net profit margin through better and efficient use of the company assets or to increase gross revenues through higher sales.
Relationship between DuPont Analysis and Return on Equity
Return on Equity ratio requires two numbers to compute: net income and shareholders' equity.
ROE = Net Income / Shareholders’ Equity
A rising ROE is generally a good sign for the company as it shows that the rate of return on the shareholders' equity is increasing. However, there can be one problem: this number can also increase when the company borrows more debt, thereby decreasing its shareholders' equity. This would hence increase the company's leverage, which could be a good thing, but it will also make the stock investment riskier.
Calculating ROE through DuPont Analysis
Return on Equity = Net income / Average Assets * Average Assets / Average Equity
= ROA * Financial Leverage
This means that Financial Leverage Ratio = Average Assets / Average Equity.
Considering the above example, the ROA of ABC Ltd is 74/500. Let's calculate its Returns on Equity ratio:
ROE = ROA * Financial Leverage or ROA * Average Assets / Average Equity
= 74/500 * 500/300
= 74/300 or 0.24
Importance of DuPont Analysis
The DuPont Analysis is a convenient and helpful tool that helps an investor look at the more detailed aspects of a company's financial health and help them make more informed investment decisions. The DuPont system is important because it provides a complete, overall picture of any company's financial health and performance, as compared to the common and limited equity valuation tools.
- In addition to informing about the Return on Investment for shareholders, DuPont analysis also includes three important indicators of the firms' performance, which provide an in-depth insight into the company's well-being. These are profitability measured by profit margin, operational efficiency measured by asset utilization (specifically asset turnover), and financial leverage measured by the assets/equity multiplier. If the ROE is higher due to the increasing operational efficiency, it is favorable for financial analysts. However, if DuPont indicates that ROE is increasing only because of increased financial leverage, then it becomes a risky investment as the increased equity returns are not a result of increased profits but of increased debts.
- DuPont analysis helps a company understand its strong factors and helps analyze the reasons behind this growth so that a healthy performance can be retained.
- It also helps identify the weak performance indicators, thus helping the company understand and improve those.
- DuPont analysis helps investors identify the source of increased or decreased equity returns.
Limitations of DuPont Analysis
Despite its many advantages and applications, the DuPont analysis also comes with a set of weaknesses, which can hamper the decision making for an investor.
- One of the DuPont analysis's major disadvantages is that it relies heavily on the data from a company's financial statements, some of which can be easily manipulated by companies, so they may not be accurate.
- Another problem includes determining the values of a company's accounting ratios as good or bad to compare them with the market value, as there are no uniform accounting methods.
- Seasonal factors, depending on the type of companies, can severely affect the accounting ratios and cannot be easily overcome.
- Different accounting practices and methods between companies can also make accurate comparisons difficult.
A simple calculation of a company's ROA and ROE may be simple and can give an idea into a company's performance, but it still does not provide the full picture. The ROA and ROE ratios are useful only when compared with the company's competitors or with the market. The DuPont analysis helps make this comparison more detailed and accurate. If a company's performance is lower than its peers, the DuPont analysis can help identify the specific figures and areas which are performing poorly, thus helping a company improve it. Similarly, for investors, DuPont can give an idea of the exact weaknesses of the company. DuPont helps understand the positive areas and the reasons behind their good performance when a company performs better than its peers. Also, for investors, DuPont analysis can help identify the company's strengths, thus helping them make a more informed decision.
DuPont Analysis is a crucial part of the Financial and Operational leverage, without which DuPont analysis can't give accurate results. Financial and operational leverage is discussed in detail in the next blog of the series.