The Dupont Formula utilizes three performance measures to illustrate whether a company can best increase its Return on Equity by maintaining a high profit margin, increasing asset turnover, or leveraging assets more effectively. Increasing any one of these three levers will increase the owners’ return.
The first two are closely related to the company’s operations, and the third part of the formula shows if leveraging how the company has been funded is most advantageous to returning equity to the owners.
Overview
While Return on Equity (ROE) shows the percentage of capital returned to the owners of a business, it does not provide insight into how the return was earned.
The Dupont Formula measures a company’s performance by analyzing what drives the current ROE using the following ratios in combination:
Profit Margin (Net Income / Sales) helps you to quantify operating efficiency as determined by profit margin and shows you the quality of earnings that result from each dollar of sales.
Asset Turnover (Sales / Total Assets) measures asset use efficiency by total asset turnover, showing how well the business uses its assets to generate sales.
Financial Leverage (Total Assets/Owners’ Equity) measures financial leverage by the equity multiplier, showing how much debt the firm has used to acquire the assets necessary to generate sales or provide services.
Increasing any one of these three levers will increase the owners’ return. The first two are closely related to the company’s operations, while the third (Financial Leverage) is how the company has been funded.
The Dupont Formula is calculated as follows:
(Net Income / Sales) X (Sales / Total Assets) X (Total Assets / Owners’ Equity)
Based on these three performance measures, the model illustrates whether a company can best raise its ROE by maintaining a high profit margin, increasing asset turnover, or leveraging assets more effectively.