DuPont Analysis Definition and Formula | Finance Strategists | Learn With Finance Strategists

hi i'm rainey with finance strategist in this lesson we're going to cover [Music] dupont analysis is a modification of return on equity or roe which uses a gross asset value rather than net asset value in its calculation it is named after dupont corporation who developed a detailed model for assessing a company's profitability in the 1920s later named dupont analysis return on equity or roe is a commonly used accounting ratio that assesses a company's profitability ratios which calculate roe measure a business's ability to generate earnings relative to its expenses return on equity is traditionally calculated by dividing net income by common equity the basic dupont analysis model breaks down the original equation for roe into three components operating efficiency asset efficiency and leverage operating efficiency is measured by net profit margin and indicates the amount of net income generated per dollar of sales asset efficiency is measured by the total asset turnover and represents the revenue generated per dollar of assets financial leverage is determined by the equity multiplier or the ratio that measures the value of a company's assets relative to the value of stockholders equity the equation for the basic dupont model is roe equals net profit margin times total asset turnover times equity multiplier we can also represent these components as ratios roe equals net income divided by sales times sales divided by total assets times total assets divided by common equity notice that the equation is still the same as return on equity since sales and total assets effectively cancel each other out net profit margin and total asset turnover assess the operations of the business the larger these components the more productive the business is the last component financial leverage captures the company's use of debt to finance its activities if a company has one million dollars of assets and 250 000 of equity its equity multiplier is four because its assets are four times greater than its equity the balance sheet will show that the company has 750 000 in debt since assets minus equity equals liabilities if the value of assets depreciates over time the equity multiplier will decrease all else being equal by borrowing more to purchase new assets management can increase the financial leverage ratio thereby increasing roe this is why basic roe analysis can be misleading the dupont model uses gross asset value which ignores depreciation instead of net asset value using gross asset value no longer incentivizes managers to borrow more and invest in new assets this encourages managers to get the most out of the useful life of the asset it's important to note that borrowing more money increases leverage and creates a higher risk of default but borrowing more isn't inherently bad if a company can borrow money at low interest rates and put capital to good use it can grow the company faster and generate higher returns for investors [Music] by breaking out the traditional return on equity equation using dupont analysis internet profit margin total asset turnover and equity multiplier investors can analyze the reason for an increase or decrease in roe if roe increases due to higher leverage rather than a greater net profit margin or asset turnover additional leverage may not be adding any real value to the firm this is why dupont analysis offers more insight than basic roe analysis [Music] let's hear from you do you think companies should use equity debt or a mix of both to finance business activities leave a comment below [Music] for more information visit finance strategists strategies for you

test attribution text

Add Comment