The DuPont analysis is a methodology used for analysing fundamental business performance, it is named after the corporation that popularised it – DuPont Corporation. DuPont analysis is used as a technique to decompose the drivers of Return on Equity (ROE) into three parts.
This technique breaks down Return on Equity to profitability (measured by profit margin), asset efficiency (measured by asset turnover), and financial leverage (measured by equity multiplier). This analysis enables the analyst to understand the source of superior (or inferior) return by comparison with companies in similar industries (or between industries).
DuPont analysis allows an investor to determine what financial activities are contributing the most to the changes in ROE. Therefore, an investor can use an analysis like this to compare the operation efficiency of two similar firms and almost instantly gain insight into the capital structure of a firm, the quality of the business, and the levers that are driving the return on invested capital. If ROE is better only by using more financial leverage, than the increased equity returns are not actually a result of increased profits and the company may be overextending financially, making it a riskier investment. While if the ROE is higher due to improved operational efficiency or utilisation of assets, then it would be interpreted favourably by analysts.
DuPont analysis is a helpful tool to make informed choices to equity holdings. The primary advantage is the fuller picture of the company’s overall financial health and performance that it provides, compared to other limited equity valuation tools. A great disadvantage of the DuPont analysis is that it heavily relies on accounting data from company’s financial statements, which can be manipulated by companies to look better. So, as usual DuPont analysis is only as good as the data that gets put into it.
In today’s economy a company often has to prove its worth to investors in order to acquire new funding. A robust financial reporting and forecasting process enables a business to meet the challenges of today’s challenging business environment. Since ProForecast update 1.6.5, you can now run a DuPont analysis with your data, and make it apart of your financial reporting.