DuPont analysis is an approach used to analyse return on equity (ROE). Under this approach, we break down ROE into operating and financing components.
The following table shows the DuPont Analysis of two fictitious companies.
By breaking down the ROE, we can analyse the components that have contributed to the returns on equity. The first component net profit margin tells how much profits the company made from its revenue. The second component asset turnover tells us how effectively the company utilized its assets and the third component equity multiplier tells us about how leveraged the company is.
In the above example, for Alpha Corp. the RoE dropped significantly from 2012 to 2013. The dip is contributed primarily to a decrease in net profit margin. The financial leverage has remained the same while asset turnover has increased slightly.
An analyst should carefully analyse the source of increase in ROE. An increase in ROE due to net profit margin is a good sign, however, increase in ROE due to increase in leverage, especially for an already leveraged company, is a warning signal.
We can further extend the DuPont equation by breaking up net profit margin into EBIT margin, tax burden and interest burden. This is called the 5-factor DuPont analysis.