DuPont analysis is concerned with the expression that breaks down the return on equity into three parts. The name of the analysis is used in assessing a company’s progress on the equity investment in comparison of companies in the similar industries (Jr, 2005.). The name of the financial ratio analysis of the DuPont was established in the 1920s. This is was as a result of the DuPont Corporation that applied the formula in the analysis of the financial relations of the equities.
The DuPont analysis is broken into three elements that are profitability, operation efficiency and equity multipliers (Jr, 2005.). This helps in analyzing the superiority source and the understanding the returns. This is enhanced by the comparison of the company’s results with other in a similar industry or the earlier results of the same company. This mode of analysis depends most on the accounting based records and identities (Jr, 2005.). They provide the basis of the records that are employed by the firms that are in the stock trade mostly as they value their returns.
Return on equity acts as the indicator of the potentiality and the profitability growth of the company. This explains the reason the companies with little or no debt to perform well in the sector. The capital expenditure that is high makes the companies investment on the shares to below hence the returns are low (Jr, 2005.). On the contrary to this, the low capital expenditure employment makes the business withdraw cash and invest somewhere else either on equities.
The investors have the knowledge of the best firm to invest in the equities as the returns are not the same. The difference in the results helps in the decision making that is appropriate inregard to the firm that has a high level of returns. To understand the rational, the investors as well as the management uses the DuPont models to determine the level of the equity return. The favorable outcome attracts the investors and at the same time the company returns are high.
Composition of the DuPont model in the financial ratio analysis
There are three components that are used in the calculation of the model in the determination of the return on equity. They consist of net profit margin, asset turnover as well as the equity multiplier (Jr, 2005.). In their comparisons, they are in the position of helping the management to identify the lack of the firm in regard to other companies. In the same analysis, they also show the status of the company whether there is an improvement in their operation.
The second approach in the determination of the equity returns is the asset turnover ratio. This helps in measuring the efficiency and effectively on how a company can convert the available assets into the sale. This is done through dividing the revenue generated with the assets that are available in the company. Asset turn over = generated revenue/ company’s assets. The investors use the asset turnover in making decisions on the company to invest in their equities (Jr, 2005.). The asset turnover tends to be inversely related with the net profit margin.
The third equity multiplier is the measure and determinant of the financial leverage. It hence helps the investor to get a clear outlook of the financial position of the company. In the unfavorable business positions, in the sales and margins gives the company a chance to take the excessive debs and apply the increase in the equity through the artificial means. The equity the formula is obtained from the division of the company’s asset with the equity that is owned by the shareholders. The equity multiplier= assets / shareholders equity.
The return on equity calculation
In the application of the DuPont model, the incorporation of the three elements helps in the calculation of the returns on equity. The components having different measures on the performance of the company are in the position of providing an identity that is used by the investors in determination of the company’s viability in the performance (Jr, 2005.). The simplified formula is the multiplication of the three components. Return on the equity = net profit margin * asset turnover * equity multiplier.
Jr, J. B. ( 2005.). Corporate Financial Policy and R & D Management. Hoboken: John Wiley & Sons.