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Wednesday, November 9, 2011

How to use the Dupont Identity to analyze business performance

The Dupont identity is a financial analysis tool used to assess the performance of corporations. According to FCS Commercial Financial Group, an advantage of the Dupont identity is it allows more in depth assessment than a single profitability ratio. This is because the formula evaluates corporate profit in terms of assets, equity leverage and actual sales figures rather than sales forecasts. When calculating the Dupont Identity, two equations are used; one is used to evaluate return on assets, and is a sub-component of the second that ultimately determines business profitability. Before elaborating the details about Dupont Identity, the video below offers a good starting point by broadly explaining the concepts of Dupont Identity and Dupont analaysis:


Components of Dupont Identity financial analysis


The three component parts of the Dupont Identity per the FCS Commercial Financial Group include return on equity, total asset turnover and the equity multiplier. These are three financial ratios that are also individually used in financial analysis. The first of these ratios determines profit margin or the percentage earnings of total revenue. The second ratio demonstrates how well a company's assets are being used in terms of generating revenue. The equity multiplier shows how much assets a company has in terms of equity capital.

1. Profit Margin: Profit/Sales
2. Total asset turnover : Sales/Assets
3. Equity multiplier: Assets/Equity

Equation(s)

The first of the two equations determines a businesses return on assets or ROA by multiplying profit margin by total asset turnover.

1. Return on Assests= Profit margin x total asset turnover

The second equation of the Dupont identity determines return on equity (ROE) by mulitplying ROA by equity leverage.

2. “Extended” DuPont Identity= Profit margin x total asset turnover x equity multiplier

Example:

A Securities and Exchange Commission corporate filing by Walmart Stores, Inc. had a July 31, 2011 quarterly profit of $3.801 billion on sales of $109.366 billion with total assets valued at $193.656 billion and equity of $67.941 billion. With these numbers the component parts of the Dupont formula can be calculated.

1. Profit margin= profit/sales= $3.801 billion/$109.366 billion =3.475%
2. Total asset turnover= sales/assets= $109.366 billion/$193.656= 56.47% (1.77 x sales)
3. Equity multiplier= assets/equity= $193.656 billion/$67.941= 2.85
   
Since Total Asset Turnover is expressed as a multiple of sales rather than the result of division, multiplying 1x2= 6.151%. Therefore, the result of the DuPont equation is which is 6.151% x the equity multiplier of 2.85 = 17.529%

The higher the extended Dupont identity is, the better a corporation is performing. This method of calculating corporate profitability enables analysts to more accurately determine the cause(s). For example, if the total asset turnover ratio is high, but profit margin and the equity multiplier are low, then it indicates strong use of assets and capital but high operational costs. 

In the case of Walmart, a strong aspect of the businesses performance seems to be derived from its total asset turnover and high equity leveraging than profit margin. This means the company makes good use of investor capital and sells a high percentage of product, but with minimal profit on each individual sale.