Question

How to calculate the DuPont equation

Answer 1

The DuPont equation is an expression which decomposes

the 'Return on Equity' [ROE] into three parts as below:

ROE = Profit margin*Total assets turnover*Equity multiplier

= [Net income/Sales]*[Sales/Total assets]*[Total assets/Shareholders' equity]

The decomposition helps in understanding the variables

underlying the ROE.

Profit margin is a measure of profitability which is relative

to the sales. It indicates the amount of net profit for every

dollar of sales. ROE can be improved by improving the

profit margin.

The assets turnover tells how many times the total assets

are turned over by sales. By increasing the assets turnover

the profitability can be multiplied.

The product of the first two ratios [Profit margin*Asset

turnover] gives the return on assets. It highlights the

efficiency achieved in operations.

The third component, the equity multiplier, is the ratio

measuring the financial leverage; that is how much of debt

is used to finance the total assets. The higher the ratio the

higher is the leverage and the higher the magnification of

Return on equity in relation to a particular return on assets.

It is possible to improve ROE by improving any one, any two

or all the three of the components.