The DuPont ratio is a widely used method for calculating a company's return on equity, or ROE. The DuPont ratio is calculated using a combination of three financial ratios: profit margin, total asset turnover and leverage ratio. The three ratios combine via the cancellation of cross-numerators and denominators to result in ROE. Profit margin and total asset turnover similarly combine to produce return on assets, or ROA. Therefore, if both ROA and total asset turnover are known, profit margin can be determined using simple arithmetic.
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If you have data on total asset turnover and return on assets available, you can use the DuPont ratio to quickly determine your profit margin .
Understanding the DuPont Analysis
One of the benefits of using the DuPont analysis is that it allows you to closely examine each component of ROE to identify whether profitability, asset utilization or financial leverage has the greatest impact on ROE. When analyzing a company's DuPont ratio, perform a historical trend analysis for all three components. If no trends are evident, this implies that the components combining to produce ROE are erratic, which is an indication of risk. It is also useful to perform a benchmark analysis in which the subject company's DuPont ratio is compared to that of a peer group – but only if the peer group is highly comparable to the subject company in terms of size and line of business.
Understanding Return on Equity
Return on equity is an important financial metric across all industries and is associated with a company's ability to generate excess earnings, which creates intangible value. ROE is also highly correlated with a company's ability to consistently generate growth in book value. ROE is equal to net income divided by total equity. However, using the DuPont analysis, ROE is equal to total profit margin x total asset turnover x leverage ratio, or (net income/sales) x (sales/total assets) x (total assets/total equity). Cross-multiplication results in the elimination of redundant numerators and denominators, leaving only net income/total equity.
Defining Return on Assets
If ROE is known and the leverage ratio is known, you can back into ROA. Assume ROE equals 25 percent and the leverage ratio is 2.5. Since ROA multiplied by the leverage ratio equals ROE, ROA must equal 25 percent divided by 2.5, or 10 percent. The leverage ratio is sometimes referred to as the leverage multiplier. As long as a company's return on invested capital is higher than its borrowing costs, than leverage will have a positive effect on the company's return on equity.
Calculating Net Profit Margin
If you know ROA and the components of total sales turnover, you can easily back into the net profit margin. For example, if total sales are $100 and total assets are $50, then total sales turnover equals $100/$50, or 2.0. If ROA is known to be 10 percent, this means that net income divided by $50 equals 10 percent. Net income, therefore, must equal $5. Net income of $5 divided by total sales of $100 results in a net profit margin of 5 percent. This can also be calculated more simply: ROA of 10 percent divided by total asset turnover of 2.0 equals a net profit margin of 5 percent.