A model for Profitability

It is important for a business to be clear on how it is making its money.  This enables it to keep being profitable and gives confidence to those who are investing in the company. In order to calculate return on equity it is useful to use the DuPont analysis.  This can be used to compare different companies and shows what elements most affect the profitability of a company.

The DuPont Analysis

The DuPont analysis was created and used by the DuPont Corporation, back in the 1920s.  It splits the Return on Equity into three components.  These are the profit margin, the asset turnover and the financial leverage. The basic equation is:

ROE = profit margin x asset turnover x financial leverage

Or

ROE = Net income/sales x sales/total assets x total assets/equity

Looking at these different components companies can gain a better understanding of how their ROE changes over time. In general different types of business will gain their main profit from different components of the equation.  Boutiques for instance have a high profit margin, selling a few items at inflated prices.  Supermarkets are an example where profit is gained mainly in asset rotation, they have a high turnover of goods, but do not have a high profit margin on each of those goods. Banks use financial leverage for a good ROE, their assets are high compared with their equity.

We will look at each of these components in turn

Profit Margin

This is profit divided by sales or the net profit over the total revenue.  This will vary according to the pricing and the cost.  If the main component of a company’s ROE is dependent on this element, cutting costs and/ or increasing the price could makes a significant difference overall.

Asset turnover

This is to do with the efficiency of your asset use.  If you have a low profit margin then you will need to have a high turnover of assets in order to increase the ROE. As asset turnover increases, more sales are made per asset owned and this contributes to greater profit.

Financial leverage

Financial leverage has to do with the use of debt for financing a company’s operations.  If a company has $5,000 worth of assets and $1,500 equity, the balance sheet will show $3,500 worth of debt.  As more money is borrowed to purchase assets, so the debt increases.  Financial leverage is calculated using average assets and dividing it by the average equity, not the balance at the end of the time period.

Debt is used in the operation of a company and for growth.  If a company wants to keep up with its competitors it is usually necessary to use some sort of debt, but it is important that too greater risk is not made in doing this.

Usefulness of the DuPont Equation

When a business relies on one factor more than the rest, the DuPont equation is useful in analysing, which factor is dominant.  In turn it shows which factor is most important for measuring. In high turnover industries, it is important to look at the asset turnover rather than worrying too much about profit margin or financial leverage.  However, for exclusive fashion and bespoke industries, it may be critical that the profit margin is maintained.  As for those in the financial sector, they need a large financial leverage in order to make their profits and this can be weighed up with the risks involved.

So this analysis can be helpful in the comparison of two similar companies.  A change in the ROE will not necessarily indicate why the change is taking place until it is broken down into its components.  Changes in the components may not show up in the overall figure. Early signs of growth or decline can be missed.  Investors will want to look out for these signs.

Limitations of the DuPont analysis

The DuPont analysis is an expanded form of the ROE.  It still uses financial data, which is possible to manipulate.  It is also important to understand that it does not show the actual reason for high or low ratios or what the bench mark is.

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