What is DuPont analysis? Explain all the ratios involved in this analysis. Your answer should be supported with the chart.

Q. What is DuPont analysis? Explain all the ratios involved in this analysis. Your answer should be supported with the chart.

Answer:

 

A method of performance measurement that was started by the DuPont Corporation in the 1920. With this method, assets are measured at their gross book value rather than at net book value in order to produce a higher return on equity (ROE). It is also known as “DuPont identity”.

 

DuPont analysis tells us that ROE is affected by three things:

  1. Operating efficiency, which is measured by profit margin
  2. Asset use efficiency, which is measured by total asset turnover
  3. Financial leverage, which is measured by the equity multiplier

 

ROE = Profit Margin (Profit/Sales) * Total Asset Turnover (Sales/Assets) * Equity Multiplier (Assets/Equity)

 

Investopedia explains DuPont Analysis

It is believed that measuring assets at gross book value removes the incentive to avoid investing in new assets. New asset avoidance can occur as financial accounting depreciation methods artificially produce lower ROEs in the initial years that an asset is placed into service. If ROE is unsatisfactory, the DuPont analysis helps locate the part of the business that is under performing.

The DuPont System expresses the Return on Assets as: ROA = OPM * ATR

The Operating Profit Margin Ratio is a measure of operating efficiency and the Asset Turnover Ratio is a measure of asset use efficiency.

The DuPont System expresses the Return on Equity as:

ROE = (ROA – Interest Expense/Average Assets) * EM

The Equity Multiplier is a form of leverage ratio and measures financial efficiency.

Below figure shows the DuPont Analysis for a farm operation

Figure: DuPont Analysis for Farm Operations

Figure: DuPont Analysis for Farm Operations

DuPont Analysis for Two Farms

Sr.No.

Farmer A

Farmer B

1

Operating profit margin ratio 0.30 0.12

2

Asset turnover 0.20 0.36

3

ROA (1*2) 0.060 0.043

4

Interest expense to avg. farm assets 0.05 0.03

5

Equity multiplier 2.00 1.50

6

ROE (3-4) * 5 0.02 0.02

 

Farmer A and Farmer B each have a 2 % ROE. The components of the ratios indicate that the sources of the weakness of the farms are different. Farmer A has a stronger profit margin ratio but lower asset turnover compared to Farmer B. Furthermore, Farmer A has a higher leverage ratio than Farmer B.

The weak ratios for each farm may be decomposed into components to determine the potential sources of the weakness. To improve asset turnover Farmer A needs to increase production efficiency or price levels or reduce current or noncurrent assets. To improve profit margins, Farmer B needs to increase production efficiency or price levels more than costs or reduce costs more than revenue.

The DuPont analysis is an excellent method to determine the strengths and weaknesses of a farm. A low or declining ROE is a signal that there may be a weakness. However, using the analysis you can better determine the source of weakness. Asset management, expense control, production efficiency or marketing could be potential sources of weakness within the farm. Expressing the individual components rather than interpreting ROE itself may identify these weaknesses more readily.

 

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