Which one of the following is not a basic component of the DuPont method of ratio analysis

What is DuPont Analysis?

DuPont Analysis is a framework used to break apart the underlying components of the return on equity (ROE) metric to determine the strengths and weaknesses of a company.

Originally devised in the 1920s by Donaldson Brown at DuPont Corporation, the chemical company, the model is used to analyze the return on equity (ROE) as broken down into different parts in order to analyze the contribution of each part.

Table of Contents

• 3-Step DuPont Analysis Formula
• DuPont Analysis Formula
• DuPont Analysis Ratios: ROE Equation Components
• 1. Net Profit Margin Ratio
• 2. Asset Turnover Ratio
• 3. Financial Leverage Ratio
• 5-Step DuPont Analysis Formula
• DuPont Analysis Calculator – Excel Model Template
• Step 1. Operating Scenarios and Balance Sheet Assumptions
• Step 2. 3-Step DuPont Analysis Calculation
• Step 3. 5-Step DuPont Analysis Calculation

3-Step DuPont Analysis Formula

In a 3-step DuPont analysis, the equation states that if a company’s net profit margin, asset turnover, and financial leverage are multiplied, you will arrive at the company’s return on equity (ROE).

As the simpler version between the two approaches, the return on equity (ROE) is broken into three ratio components:

1. Net Profit Margin = Net Income ÷ Revenue
2. Asset Turnover = Revenue ÷ Average Total Assets
3. Financial Leverage Ratio = Average Total Assets ÷ Average Shareholders Equity

The starting point to arrive at these three components is the return on equity (ROE) formula.

Return on Equity (ROE) = Net Income ÷ Average Shareholders’ Equity

If we multiply the ROE formula above by two ratios: 1) “Revenue ÷ Revenue” and 2) “Average Total Assets ÷ Average Total Assets”, we are essentially multiplying the ROE by one, since the numerator and denominator are the same in both ratios.

But with some re-arranging of the terms, we arrive at the three standard ratios mentioned earlier:

• Ratio #1 → Net Profit Margin
• Ratio #2 → Asset Turnover Ratio
• Ratio #3 → Leverage Ratio

DuPont Analysis Formula

The 3-step DuPont formula shown below is the most commonly used equation:

Upon splitting up the return on equity (ROE) calculation into these three components, the changes in ROE can be better understood and what is driving the net increase (or decrease).

The DuPont analysis implies that a company can increase its ROE if it:

• Generates Higher Net Profit Margin
• Efficiently Utilizes Assets to Generate More Revenue
• Increases its Financial Leverage

DuPont Analysis Ratios: ROE Equation Components

1. Net Profit Margin Ratio

Net Profit Margin = Net Income ÷ Revenue

• The net profit margin represents a company’s “bottom line” profitability once all expenses have been deducted, including the interest expense payments on debt obligations and taxes to the government.
• If the net profit margin increases, each dollar of revenue will bring in more earnings to the company, resulting in a higher return on equity (ROE).
• Therefore, a company’s net income represents the remaining profits left over, which are attributable to one specific group of capital providers – the equity shareholders.

2. Asset Turnover Ratio

Asset Turnover = Revenue ÷ Average Total Assets

• For the second component, the total asset turnover ratio is an efficiency ratio tracking the ability of a company to generate more revenue per dollar of asset owned.
• If a company improves upon its turnover ratio, the ROE increases because the implication is that it can utilize its assets better – i.e. generate more revenue with fewer assets.
• The first two components – the net profit margin and total asset turnover – represent measures of operating efficiency and asset efficiency.

3. Financial Leverage Ratio

Financial Leverage Ratio = Average Total Assets ÷ Average Shareholders Equity

• The third and final component is financial leverage, which is the amount of debt in the company’s capital structure.
• The use of more debt financing leads to higher interest expenses, which are tax-deductible and create a “tax shield” that reduces the amount of taxable income.
• Often called the “equity multiplier,” increasing the amount of debt to benefit from the lower taxes, the lower cost of capital, and obtaining access to a cheaper funding source could easily backfire from irresponsible decision-making. Hence, the company must be led by a management team with their interests aligned with that of its shareholders.
• The company must strike the right balance between benefiting from debt financing but not placing excess leverage on the company, where the company’s cash flows are insufficient to handle all the debt obligations and are now at risk of default.

5-Step DuPont Analysis Formula

The five components of the 5-step DuPont formula are the following ratios:

1. Tax Burden = Net Income ÷ Pre-Tax Income
2. Asset Turnover = Revenue ÷ Average Total Assets
3. Financial Leverage Ratio = Average Total Assets ÷ Average Shareholders’ Equity
4. Interest Burden = Pre-Tax Income ÷ Operating Income
5. Operating Margin = Operating Income ÷ Revenue

There are two additional components in the 5-step equation as compared to the 3-step equation. To expand further upon the additional parts of this formula:

• Tax Burden → The proportion of profits retained post-taxes.
• Interest Burden → The extent to which interest expense impacts profits
• Operating Margin → The operating profit (EBIT) retained per dollar of sales after deducting cost of goods sold (COGS) and operating expenses (OpEx).

All three of these new parts are extensions of the net profit margin calculation.

Net Profit Margin = EBIT Margin × Tax Burden × Interest Burden

DuPont Analysis Calculator – Excel Model Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

Step 1. Operating Scenarios and Balance Sheet Assumptions

Suppose we’re tasked with calculating a company’s return on equity (ROE) using the DuPont analysis framework.

Here, we’ll be assessing three different operating scenarios:

1. “Downside” Case
2. “Base” Case
3. “Upside” Case

For our projections, we’ll use the “Downside” case as our starting point. We’ll also use a step function and use different step values for the other two cases.

Downside Case:

• Revenue: $200m
• Cost of Goods Sold (COGS): –$140m
• Operating Expenses (OpEx): –$40m
• Interest Expense: $0m

Then, from those figures, we’ll use the following step functions – i.e. the value of the hard-coded number in blue font is added to the cell on the left.

Base and Upside Case (I/S Step Function):

• Revenue: +$50m
• COGS: –$10m
• OpEx: –$10m
• Interest Expense: –$10m
• Tax Rate: 25% – Constant in Each Case

Next, we’ll move on to the balance sheet assumptions, for which we only require two data points, the “Average Total Assets” and “Average Shareholders’ Equity” accounts.

B/S Downside Case:

• Average Total Assets: $500m
• Average Shareholders’ Equity: $500m

B/S Base and Upside Case (Step Function):

• Average Total Assets: –$50m
• Average Shareholders’ Equity: –$100m

Since there is no debt in the capital structure in the “Downside” case, the total assets must equal the average shareholders’ equity for the balance sheet to remain in balance.

Step 2. 3-Step DuPont Analysis Calculation

We now have all the required inputs to calculate ROE using both the 3-step and 5-step DuPont approaches.

To calculate the ROE under the 3-step approach, we can use the following formula:

Return on Equity (ROE) = Net Profit Margin x Total Asset Turnover x Financial Leverage Ratio

Step 3. 5-Step DuPont Analysis Calculation

In the final part of our modeling exercise, we’ll calculate the ROE under the 5-step approach.

The formula for calculating each input is listed on the side, while the ROE formula can be seen in the highlighted cells.

Return on Equity (ROE) = Tax Burden × Asset Turnover × Financial Leverage Ratio × Interest Burden × Operating Margin

From our completed model output, the return on equity (ROE) comes out to:

• ROE, Downside Case = 3.0%
• ROE, Base Case = 7.5%
• ROE, Upside Case = 15.0%

The fact that the ROE is equal in both the 3-step and 5-step approaches confirms that the formulas in our model are correct, as well as how the two are fundamentally identical.

Simply put, the 5-step approach takes the basic approach a tad bit further by getting more into the specifics regarding net income.

In our hypothetical scenario, the two major contributors to the variance in ROE values were the following:

1. Margin Expansion in Profitability (i.e. Net Profit Margin, Operating Margin)
2. Increased Efficiency in Utilization of Assets to Generate Revenue (i.e. Total Asset Turnover)