Question

What is the DuPont formula and how is it used to improve a firm’s financial performance?

Answer 1

The DuPont formula breaks the ROE [Return on Equity] formula into three components:

ROE = Net profit margin*Asset turnover*Equity multiplier

where,

Net profit margin = Net income/Sales

Asset turnover = Sales/Average total assets, and

Equity Multiplier = Average total assets/Average shareholders' equity

The ROE can be improved by improving the value of any or all of the three component ratios.

Net profit margin can be improved by conrolling the cost of goods sold and the operating costs as well as by improving the net sales realizations.

Asset turnover can be improved by improving the efficiency in utilizing the assets in generating income. More the turnover more the efficiency.

The equity multiplier is the fianancial leverage measure. Higher the debt content, higher the magnification of the ROA into ROE, though there is a limit to the maximum equity multiplier [maximum debt proportion] that can be had, as debt increases risk.

So, the ROE can be improved by improving the component factors which have a multiplicative effect on