Financial Statement Analysis

Chapter 3Analysis of Profitability Using the DuPont Analysis

Learning objective

• Identify what a DuPont analysis is.

Introduction

The purpose of this section is to discuss how the DuPont system enables one to examine a firm’s financial statements to determine what, if anything, is causing its return on investment or return on equity to fall short of expectations. This is accomplished by breaking these returns into three component parts: profit margin, asset turnover, and return on assets. Only when that area of weakness is identified can management take appropriate steps towards improvement.

DuPont system

The DuPont System allows us to examine a company’s financial statements and see where its profitability problems (if any) come from. The return on equity is broken down into the return on assets [net income/total assets] and into the equity multiples [total assets/total equity]. The product of the equity multiples and the return on assets is the return on equity.

Knowledge check

1. The DuPont system is a way of breaking down the return on equity into its component parts. One can find the return on equity is by multiplying the Return on Assets (ROA)times
   1. The equity multiplier.
   2. Debt to asset ratio.
   3. Asset turnover.
   4. Three.

This part of the breakdown shows that debt usage, as measured by the equity multiplier, can “lever up” the ROE. The more debt a company has, the larger ...