Hi, welcome to this edition of the ‘Financial analysis techniques’ series. So far in this series we have discussed different types of important ratios and their interpretation like activity ratios, liquidity ratios, solvency ratios and profitability ratios. In today’s post we will analyze and interpret the most important profitability ratio – ROE i.e. return on equity, through a technique called the DuPont analysis. Du Pont analysis technique is a very important concept in finance which every finance student should know about. Read on to learn more about this concept…. but before you do that I recommend you go through the previous posts in this series mentioned above to get a better understanding of the ratios discussed below…
DuPont analysis of Return on Equity (ROE)
Returns is what matters the most to any investor of capital at the end of the day. This makes Return on Equity (ROE) one of the most important ratios in finance as it measures the returns earned by the owner’s of capital on their investment.
To understand and analyze what drives the ROE, it can be studied by decomposing it into parts. This method of decomposing the ROE is called Du Pont analysis after the company in which this technique was first developed and used. So what is the DuPont analysis? How exactly does it work?
In Du Pont analysis, the basic ROE ratio is decomposed into component ratios, each component representing an aspect of the company’s performance that affects the ROE. The Du Pont analysis interpretation comes in two variants, the original Du Pont equation or the 3 way DuPont equation as it is known and the 5 way DuPont equation. Let us approach each of these interpretations one at a time and see how to calculate Du Pont analysis.
Original Du Pont Analysis or 3 way DuPont analysis
First stage of the3 way DuPont analysis
In the original or 3 way DuPont analysis, the basic ROE is decomposed into three parts in two stages. In the first stage of the analysis we will decompose the ROE ratio into two parts and in the second stage into three parts.
We have already covered in the post on Profitability ratios that the basic ratio for ROE is given as;
ROE = Net Income / average equity
This basic ROE ratio can be decomposed into two parts in two ways. One way of decomposing the ROE into DuPont analysis formula is;
ROE = Net income / average total assets × average total assets / average equity
i.e, ROE = ROA × Leverage
From the above DuPont equation, it can be seen that Return on Equity is a function of return on assets and the use of financial leverage. ROE can be improved by increasing the ROA and by increasing the use of leverage. However, further in the post we will see that increasing leverage need not always increase the ROE.
The second way in which the ROE can be expressed as a DuPont formula is;
ROE = Net Income / revenue × revenue / average equity
i.e. ROE = Net profit margin × equity turnover
From the above DuPont equation we can see that ROE can also be stated as a function of the net profit margin and the efficiency with which the company uses its equity to generate revenue.
Second stage of the 3 way DuPont analysis
In the second stage of the 3 way DuPont analysis we will decompose the equation further into a DuPont formula having three parts as follows;
ROE =Net income/revenue × revenue/avg total assets × avg total assets/ equity
i.e. ROE = Net profit margin × asset turnover ratio × leverage ratio
This is the three-part original Du Point analysis. As we can see the ROE, as expressed in this DuPont equation, is a function of the net margin ratio, the efficiency with which the assets are used to generate revenue and the use of financial leverage.
If the ROE is too low, it could be either due to low net profit, or because the firm does not utilize its assets efficiently or it uses less than the optimal amount of leverage in its capital structure.
Extended DuPont analysis or 5 way DuPont analysis
In the extended Du Point analysis or 5 way DuPont analysis as it is called, the ROE is decomposed further into five parts, by dividing the first component, i.e. Net profit margin into three parts. The 5 way DuPont analysis formula is given as;
ROE = Net income/EBT ×EBT/EBIT × EBIT/revenue ×asset turnover ×leverage
ROE = Tax burden ×interest burden ×EBIT margin ×asset turnover ×leverage
Net income/EBT is called the tax burden as it measures how much of the pretax profits remain with the company after paying taxes.
EBT/EBIT is called the interest burden as it measures how much of the company’s operating profits are left over after making interest payments.
An increase in interest payments will increase the interest burden and lower the interest burden ratio as the EBT in the numerator will be much smaller than the EBIT in the denominator. A lower interest burden ratio will decrease the ROE. Similarly, an increase in tax burden will decrease the tax burden ratio, which in turn will decrease the ROE. Decrease in operating profits will decrease the EBIT margin and in turn decrease the ROE. Again, decrease in leverage ratio will decrease the ROE due to non optimal use of leverage.
Similarly, an increase in either of these component ratios will increase the ROE. However, it should be noted that an increase in leverage ratio need not always increase the ROE. This is because an increase in leverage (debt) will also increase the interest burden and thus decrease the interest burden ratio. Therefore, an increase in the ROE through an increase in the leverage ratio will be offset by a decrease in the interest burden ratio.
This can be understood intuitively as well. A large increase in interest payment expenses will decrease the profits of the firm, thus offsetting the benefits of higher use of leverage.
So, this is how decomposing the ROE let’s us study the different aspects affecting it individually and take action where needed to improve the ROE.
That’s all in this post on folks…hope you found it useful and will not hesitate to share it with others…in the next post we will cover the calculation and interpretation of ratios used in equity analysis….do check in again then…see ya
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