EN.662.611 Chap.8 DuPont Analysis and Financial Statement Analysis
DuPont Analysis and Financial Statement Analysis
The purpose of the DuPont system
DuPont analysis organizes the drivers of return on equity. In the course it supplies the headline of a financial statement analysis and shows where to look for the story behind it.
Return on equity is split into three levers: profitability, measured by net profit margin and driven by cost control on the income statement; efficiency, measured by total asset turnover and driven by asset management on the balance sheet; and leverage, measured by average total assets over average total equity and driven by how far debt is used to magnify returns.
Reward and risk
Profitability times efficiency gives return on assets, which the lecture treats as the reward from performance.
Leverage multiplies that reward into return on equity, but it does so by adding risk. A rise in return on equity driven only by leverage is therefore not the same as a rise driven by better margins or faster asset use.
The pyramid of supporting ratios
The course's return on equity pyramid places the supporting ratios under each lever.
Under profitability sit the common-sized income statement, earnings per share, gross profit and operating profit percentages, the dividend payout ratio and cash flow yield. Under efficiency sit receivables, inventory and payables turnover, their day counts, fixed asset turnover and the cash conversion cycle.
Under leverage sit the current and quick ratios, the debt and debt-to-equity ratios and times interest earned.
From headline to explanation
A written analysis opens with one sentence: the size and direction of the change in return on equity, the levers that drove it and the lever that offset it. Each lever is then explained with the ratios beneath it.
For profitability the key test is whether operating margin moved with net margin, because a gain carried by a one-time non-operating item is not likely to recur.
Writing the analysis the course asks for
The course's objectives include integrating qualitative and quantitative information and communicating recommendations clearly.
In practice that means pairing the ratio story with the business story: a strategic review of strengths, weaknesses, opportunities and threats explains why a margin fell or an asset base grew, and the ratios show how much. A strong analysis ends with a view on what happens next, not only a summary of what happened.
What this chapter covers
- 01
Return on equity and its three levers
- 02
Net profit margin and cost control
- 03
Total asset turnover and asset management
- 04
Financial leverage, risk and return on assets
- 05
The return on equity pyramid
- 06
Writing a DuPont headline
- 07
Recurring versus one-time drivers
Worked example · free
Decompose return on equity
- 1Net profit margin: $90,000 divided by $1,500,000 is 6.0%.
- 1Total asset turnover: $1,500,000 divided by $1,200,000 is 1.25.
- 1Financial leverage: $1,200,000 divided by $500,000 is 2.4.
- 1Return on assets: 6.0% times 1.25 is 7.5%.
- 1Return on equity: 7.5% times 2.4 is 18.0%, which equals $90,000 divided by $500,000.
Key terms
- DuPont Analysis
- A decomposition of return on equity into net profit margin, total asset turnover and financial leverage.
- Net Profit Margin
- Net income divided by net sales, the profitability lever of return on equity.
- Total Asset Turnover
- Net sales divided by average total assets, the efficiency lever of return on equity.
- Financial Leverage
- Average total assets divided by average total equity, the risk lever of return on equity.
- Return on Assets
- Net income divided by average total assets, equal to net profit margin times asset turnover.
- Common-Sized Statement
- An income statement with every line shown as a percentage of net sales.
DuPont Analysis and Financial Statement Analysis FAQ
Why is leverage called risk rather than performance?
Leverage raises return on equity by financing more assets with debt, not by earning more on those assets. The same debt that lifts returns in a good year deepens losses in a bad one.
What should follow the DuPont headline in a written analysis?
An explanation of each lever using the ratios beneath it in the pyramid, ending with a judgment on whether the change is likely to last and what a reader should watch next.
How do I tell whether a margin gain will last?
Compare operating profit percentage with net profit margin. If only net margin rose, the gain probably came from non-operating items such as a one-time settlement, which will not repeat next year.
Exam move
Choose one company's two most recent years, compute the three levers and their percentage changes, and write the one-sentence headline. Then add one supporting ratio under each lever and one sentence on whether the change will last.
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