Du-Pont Analysis Is A Most Important Ratio To Analyze Firm’s Performance.

Du-Pont system is a comprehensive method of financial analysis first used and popularized by Duquoin Corporation.

It is used to make a classified assessment of the link between firm’s profitability, operating efficiency, assets management, and debt management. A simple Du-Pont System links return on firm’s assets as a function operating efficiency measured by net profit margin and the assets as a function of operating efficiency meausered by net profit margin and the assets products measure by total assets turn over. It is stated as:

ROA = Profit Margin * Assets Turnover

By using the simple Du-Pont equation, ratio analysis can assess how firm’s return on assets is affected by profit margin and assets turnover. Profit margin and assets turnover have a multiplier effect on firms return on assets.

For example, given a profit margin of the firm, if assets turnover increases the return on assets also increases proportionally. Putting in other words, for a given level of assets turnover, the return on assets increases proportionally with the profit margin. Thus by using simple Du-Pont system of financial analysis, the analyst can understand the contributing factor for a given level of return on assets.

Extended Du-Pont Equation

ROE = Profit Margin * Assets Turnover * Equity Multiplier

Another Du-Pont equation is in an extended form which links forms and return on equity with profit margin, assets turn over and equity multiplier.

According to extended Du-Pont analysis, firm’s return on equity depends on operating efficiency denoted by profit margin, assets utilization denoted by assets turnover and use of debt and equity indicated by equity multiplier.

Besides the profit margin on assets turnover, a firm’s return on equity is also affected by equity multiplier. The equity multiplier represents the use of debt by firms. Other things held constant, use of high debt then equity increases equity multiplier and does also its operating efficiency its profit margin will also be lower causing it to ROE to decline.

If the firm’s investment in assets are not productively utilized to generate sales revenue, the assets turnover also will be lower resulting in lower ROE. Thus by using an extended form of Du-Pont system of financial analysis, a financial analyst can make a classified assessment of the causing factors for a given level of ROE.

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