What is DuPont Analysis in ROE?

In our previous blog (https://www.rachanaranade.com/blog/what-is-return-on-equity-roe), we explored the concept of ROE. To expand on that topic, I would like to introduce you to another captivating concept of DuPont Analysis within the context of ROE.

Continuing with our "What is__?" series, let us understand what DuPont analysis is in relation to ROE and uncover its distinctions from the conventional ROE calculations.

As we have understood in our previous blog, when it comes to assessing a company's financial health and performance, Return on Equity (ROE) is a key metric that investors and analysts often rely on. ROE provides valuable insights into how effectively a company is utilizing its shareholders' equity to generate profits. However, understanding real reasons behind changes in ROE can often be complex. And that's where DuPont Analysis comes into play. DuPont analysis is a useful technique that divides the ROE in its multiple drivers. This helps the investor in understanding which areas the company have improved and to understand how it has affected the overall ROE of the company.

The DuPont Model was first developed in a company named DuPont Corporation back in 1920s. Thereafter it has gained a widespread recognition and has become a foundational tool in financial analysis, aiding investors, and businesses in assessing operational efficiency and profitability. The DuPont model deconstructs ROE into net profit margin, asset turnover, and equity multiplier (better known as financial leverage) and offers insights at these respective levels and simultaneously keeps lookout for the overall ROE of the company as well.

In essence, DuPont analysis is a useful technique used to decompose the different drivers of return on equity for a business. This allows an investor to determine what financial activities are contributing the most to the changes in ROE.

Formula for calculating ROE as per DuPont analysis is given below:

Effectively this is same as calculation of ROE (i.e., Net Profit / Shareholders Equity)

Let us better understand this with the example of ABC Company Ltd.

Now if we calculate ROE of the company for both the years it will be as follows:
For, Year 1:
ROE = (Net Profit for the year / Shareholder’s Equity)
= (80,000/3,50,000) = 22.86 %

For, Year 2 under Scenario A, B and C:
ROE = (Net Profit for the year / Shareholder’s Equity)
So, for Scenario A, ROE = 27.91%
For Scenario B, ROE = 28.57%
And For Scenario C, ROE = 26.37%

Now, the traditional ROE might say that the company is better performing than the last year under all the scenarios. But if we do a DuPont analysis of the company, we get following results.

For, Year 1:
ROE = (Net Profit for the year / Revenue) * (Revenue / Avg Total Assets) *
(Average Total Assets / Shareholder’s Equity)
= (80,000 / 10,00,000) * (10,00,000 / 5,00,000) * (5,00,000 / 3,50,000)
= 8% * 200% * 142.86% = 22.86%

Similarly, for Year 2 we get the following results under all the scenarios:

From the DuPont analysis, we understand the actual contributor to the ROE of the company. Under Scenario A we can see that other constituents are remaining constant and hence not affecting the ROE of the company. ROE of the company has improved only because the company has borrowed additional funds and improved its financial leverage. Therefore, we can say that increase in ROE is being fuelled by increasing the financial leverage of the company only. This may show that this growth in ROE is not real as even after borrowing additional funds, the company was not able to improve it other two ratios.

Similarly, for Scenario B other ratios have remained same and only Net Profit Margin has increased. This has led to the rise in overall ROE of the company. Improvement in profit margin shows that the company is able to increase its sales at a higher percentage than increase in costs. This is considered as a positive sign.

For Scenario C, other ratios have remained constant and only Asset Turnover Ratio has increased. Therefore, ROE of the company has increased only due to increase in asset turnover ratio of the company. Asset turnover ratio indicates how efficiently the assets of the company are utilised and higher ratio indicates that the company has improved its efficiency in asset utilisation. This can also be considered as a positive sign.

While DuPont analysis offers valuable insights, it also has some limitations. As the calculation is dependent on several inputs, gathering all these multiple inputs complicates its application. Additionally, its accuracy relies on the accuracy of all these inputs and even if one of the inputs is not correct, it affects the entire calculation. It is also heavily reliant on data from financial statements which may be inaccurate and are susceptible to manipulation. Also comparing ratios with that of company from a different industry poses challenges and differing accounting practices across companies hinder accurate comparisons. Seasonal influences can also distort ratios due to industry-specific fluctuations.

In conclusion, though DuPont Analysis has its disadvantages, it is still a helpful tool in analysing ROE of a company because it is more expansive in nature than conventional ROE calculation and hence provides better insights for an investor.