This tool allows the analysis of profitability of the company through the various components that are part of the calculation. Thus analyzing each party can understand the reasons why we found the rate of return on equity in a given period.
Net Sales Margin is an important element of measurement of the net profit, related to Net Sales. The higher the Net Sales Margin is the better for shareholders.
The Asset turnover ratio indicates the efficiency in the use of assets. It is the measure of how many times the asset turned in the done period. A low profit margin indicates the possibility of high asset turnover. On the contrary, it indicates the possibility of low asset turnover.
Return on investment (ROI) is performance measure used to evaluate the efficiency of investment. Equity multiplier, also called financial leverage signalizes the capacity that the company has to finance investments without need for equity.
A high leverage is too risky, especially in the occurrence of credit problems or sales, the company may become insolvent.
The financing of assets to liabilities has a financial risk by not be certain whether the return on assets can cover the financial costs of funding.
There is little point that the profit margin is high or that assets operate efficiently if they have to pay high financial costs that end up absorbing the return obtained for the assets.
Return on Equity (ROE) is a measure of efficiency, of the profit generation capacity related to the shareholder capital. The higher the ROE is the better for shareholders. The changes in equity should be analyzed carefully in order to verify, how the ROE was changed, only by shareholders' equity. Say, if near at the end of the reporting exercise, the company made capital contribution and remained in the pattern of earnings growth, ROE gets smaller, because of this event, however, without any mismanagement of the resources of shareholders.
Net Sales Margin = Net Income / Net sales;
ROI = (Net sales Margin) X (Asset Turnover) or:
ROI = (Net income /Net sales) X (Net sales / Total assets), (duPont formula), simplifying everything we have now:
ROI = Net income / Total Asset;
ROE = (ROI) X (Equity multiplier) or:
by decomposing we have:
ROE = (Net income / Total Assets) X (Total Assets) / Common Equity).
Finally, simplifying everything we have now:
ROE = Net income / Common Equity.
From the DuPont analysis, we conclude, in short, that a company can get high return on equity, as follows: increasing the profit margin, using assets more efficiently and last, a high financial leverage.
How to calculate financial ratios by theDuPont system.
DuPont Analysis Investments - Net Present Value Discounted Cash Flow (DCF) Internal Rate of Return (IRR) Modified Internal Rate of Return (MIRR) Average Interest Rate Average Rate of Return Break-Even Point in Quantities Break-Even Point (BEP) in Sales French Amortization System Constant Amortization System German Amortization System Sinking Fund American Amortization System Amortization - Average Constant and French Straight Line Depreciation Method Sum of Digits Depreciation Method (SYD) Balance Sheet Analysis Cash Flow Statement by Direct Method Cash Flow Statement by Indirect Method