The DuPont framework (also known as the DuPont equation, DuPont Model or the DuPont method) is an equation that allows the company’s stakeholders to understand the return on equity (net income/equity) through multiplying three parts. Return on equity is vital because it is an important measure of a firm’s performance and potential growth. This system provides a structure where we can determine a firm’s strengths and weaknesses and its effect on the return on equity.
1.) Profitability (profit margin = net profit/sales)
2.) Operating efficiency (asset turnover = sales/assets)
3.) Financial leverage (equity multiplier = assets/equity)
Profitability- identifies the company’s ability to produce net income per dollar of sales. Even though the common consensus is that the higher the net profit margin the more preferable it is, executives may often intentionally decrease this ratio this in an attempt to attract an increase in sales.
Operating Efficiency- how the company creates sales through utilizing its assets. Asset turnover tends to have an inverse relationship with profit margin, meaning that if a firm has a high profit margin it generally has a low asset turnover.
Financial Leverage- how much a company relies on borrowed funds rather than invested funds. A Company can be deceitful by having sub-par profitability and operating efficiency, yet still have a high return on equity by taking on an excessive amount of debt. This excess amount of debt increases the financial leverage ratio and boots the return on equity.
Through the DuPont framework, stakeholders such as management, creditors, and investors are more able to analyze and compare different firms across different measures that ultimately relate to profitability. The analyst should always consider that even though a company may have a higher return on equity than another, it does not necessarily mean it that it is a more attractive company.