DuPont System
A system of analysis has been developed that focuses the attention on all three critical elements of the financial condition of a company: the operating management, management of assets and the capital structure. This analysis technique is called the "DuPont Formula". The DuPont Formula shows the interrelationship between key financial ratios. It can be presented in several ways.

The first is:

Formula 7.41
Return on equity (ROE) = net income / total equity

If we multiply ROE by sales, we get:
Return on equity = (net income / sales) * (sales / total equity)

Said differently:
ROE = net profit margin * return on equity

The second is:

Formula 7.42
Return on equity (ROE) = net income / total equity

If in a second instance we multiply ROE by assets, we get:
ROE = (net income / sales) * (sales / assets) * (assets / equity)

Said differently:
ROE = net profit margin * asset turnover * equity multiplier

Uses of the DuPont Equation
By using the DuPont equation, an analyst can easily determine what processes the company does well and what processes can be improved. Furthermore, ROE represents the profitability of funds invested by the owners of the firm.

All firms should attempt to make ROE as high as possible over the long term. However, analysts should be aware that ROE can be high for the wrong reasons. For example, when ROE is high because the equity multiplier is high, this means that high returns are really coming from overuse of debt, which can spell trouble.

If two companies have the same ROE, but the first is well managed (high net-profit margin) and managed assets efficiently (high asset turnover) but has a low equity multiplier compared to the other company, then an investor is better off investing in the first company, because the capital structure can be changed easily (increase use of debt), but changing management is difficult.

More Useful Dupont Formula Manipulations
The DuPont formula can be expanded even further, thus giving the analyst more information.

Formula 7.43
ROE = (net income / sales) * (sales / assets) * (assets / equity)

If in a third instance we substituted net income for EBT * (1-tax rate), we get:

ROE =(EBT/sales) * (sales / assets) * (assets / equity)* (1-tax rate)

Formula 7.44
ROE = (net income / sales) * (sales / assets) * (assets / equity)

If in a forth instance we substituted EBT for EBIT - interest expense, we get:

ROE = [EBIT / sales * sales / total assets - interest / total assets] * total assets / equity * [1 - tax / net before tax]

Said differently:

ROE = operating profit margin * asset turnover - interest expense rate * equity multiplier * tax retention
Uses and Limitations of Financial Ratios

Related Articles
  1. Managing Wealth

    Understanding the DuPont Analysis

    DuPont analysis measures assets at their gross book value, rather than at net book value, in order to produce a higher return on equity (ROE).
  2. Investing

    Decoding DuPont Analysis

    Get a deeper understanding of ROE with these three-step and five-step calculations.
  3. Investing

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
  4. Investing

    Analyzing UPS's Return on Equity (ROE) (UPS)

    Learn about UPS's return on equity (ROE), an important metric for investors. It is useful to compare the historical ROE and in relation to peers.
  5. Investing

    Analyzing Facebook's Return on Equity (FB)

    Learn about Facebook's return on equity (ROE), and find out how it compares to its peers. Discover how net margin, asset turnover and financial leverage impacted its ROE.
  6. Investing

    Analyzing BP's Return on Equity (ROE)

    Examine the return on equity (ROE) for British Petroleum, the slumping international energy company that seems to be falling behind its competitors.
  7. Investing

    Analyzing Boeing’s Return on Equity (ROE) (BA)

    Learn about Boeing's return on equity and find out how the company's ROE compares to its own historical performance and aerospace industry peers.
  8. Investing

    Analyzing Southwest's Return on Equity (ROE) (LUV)

    Find out how Southwest's net margin, asset turnover and financial leverage impact return on equity (ROE). How does its ROE compare to peers and historical results?
  9. Investing

    Analyzing Microsoft's Return on Equity (ROE) (MSFT)

    Discover a detailed analysis of Microsoft's historical return on equity, and learn how its ROE stacks up to its competitors in the tech industry.
  10. Investing

    Analyzing Verizon's Return on Equity (ROE) (VZ)

    Learn about Verizon's return on equity and find out how ROE is influenced by net profit margin, asset turnover ratio and financial leverage.
Frequently Asked Questions
  1. Do interest rates increase during a recession?

    Learn why interest rates do not rise in a recession; in fact, the opposite happens. Identify the factors that reduce interest ...
  2. What is the difference between deflation and disinflation?

    Learn what deflation and disinflation are, how supply and demand affect price levels, and the difference between deflation ...
  3. What rights do all common shareholders have?

    Learn what rights all common shareholders have, and understand the remedies that can be taken if those rights are violated ...
  4. What does CHIPS UID mean?

    Learn what CHIPS UID stands for and how it facilitates the transfer of funds as the back-end of the ACH network for both ...
Trading Center