By the end of this section, you will be able to:
- Calculate profit margin to determine how much sales revenues the firm has translated into income.
- Evaluate firm performance by calculating return on total assets and return on equity.
- Analyze organizational performance using DuPont method calculations.
Profitability considers how well a company produces returns given its operational performance. The company needs to use its assets and operations efficiently to increase profit. To assist with profit goal attainment, company revenues need to outweigh expenses. Let’s consider three profitability measurements and ratios: profit margin, return on total assets, and return on equity.
Profit Margin
Profit margin represents how much of sales revenue has translated into income. This ratio shows how much of each $1 of sales is returned as profit. The larger the ratio figure (the closer it gets to 1), the more of each sales dollar is returned as profit. The portion of the sales dollar not returned as profit goes toward expenses. The formula for profit margin is
6.35
For Clear Lake Sporting Goods, the profit margin in the current year is
6.36
This means that for every dollar of sales, $0.29 returns as profit. If Clear Lake Sporting Goods thinks this is too low, the company would try to find ways to reduce expenses and increase sales.
Return on Total Assets
The return on total assets measures the company’s ability to use its assets successfully to generate a profit. The higher the return (ratio outcome), the more profit is created from asset use. Average total assets are found by dividing the sum of beginning and ending total assets balances found on the balance sheet. The beginning total assets balance in the current year is taken from the ending total assets balance in the prior year. The formula for return on total assets is
6.37
6.38
For Clear Lake Sporting Goods, the return on total assets for the current year is
6.39
6.40
The higher the figure, the better the company is using its assets to create a profit. Industry standards can dictate what an acceptable return is.
Return on Assets
This video explains how to calculate return on assets and how to interpret the results. The video provides the formula, a discussion of the concept, and the importance of the ratio.
Return on Equity
Return on equity measures the company’s ability to use its invested capital to generate income. The invested capital comes from stockholders’ investments in the company’s stock and its retained earnings and is leveraged to create profit. The higher the return, the better the company is doing at using its investments to yield a profit. The formula for return on equity is
6.41
6.42
Average stockholders’ equity is found by dividing the sum of beginning and ending stockholders’ equity balances found on the balance sheet. The beginning stockholders’ equity balance in the current year is taken from the ending stockholders’ equity balance in the prior year. Keep in mind that the net income is calculated after preferred dividends have been paid.
For Clear Lake Sporting Goods, we will use the net income figure and deduct the preferred dividends that have been paid. The return on equity for the current year is
6.43
6.44
The higher the figure, the better the company is using its investments to create a profit. Industry standards can dictate what an acceptable return is.
The DuPont Method
ROE in its basic form is useful; however, there are really three components of ROE: operating efficiency (profit margin), asset usage (total asset turnover), and leverage (equity ratio). This is known as the DuPont method. It originated in 1919 when the DuPont company implemented it for internal measurement purposes.2 The DuPont method can be expressed using this formula:
6.45
Profit margin indicates how much profit is generated by each dollar of sales and is computed as shown:
6.46
Total asset turnover indicates the number of sales dollars produced by every dollar invested in capital assets—in other words, how efficiently the company is using its capital assets to generate sales. It is computed as shown:
6.47
The equity multiplier measures leverage. It is computed as shown:
6.48
Using DuPont analysis, investors can see overall performance broken down into smaller pieces, which helps them better understand what is driving ROE. We already have the computations for Clear Lake Sporting Goods’ profit margin and total asset turnover:
6.49
6.50
We can calculate the equity multiplier using the equity multiplier equation and prior calculations for Clear Lake’s average total assets and average stockholder equity:
6.51
6.52
6.53
6.54
Now that we have all three elements, we can complete the DuPont analysis for Clear Lake Sporting Goods:
6.55
6.56
The DuPont Method
This video about the DuPont method walks through its history, discusses its basic components, and shows how to calculate and interpret each measurement.
Performance Analysis
ROE captures the nuances of all three elements. A good sales margin and a proper asset turnover are both needed for a successful operation. Like all ratios, assessing performance is relative. It’s important to look at the ratio in context of the organization, its history, and the industry. If we compare Clear Lake’s ROE of 26.4% to the recreational products industry average of 12.56% for the same year, it would appear as though Clear Lake Sporting Goods is outperforming the general industry. However, recreational products can include a wide variety of businesses beyond just the outdoor gear in which Clear Lake Sporting Goods specializes. An analyst could look at other key competitors such as Cabela’s or Bass Pro Shops to get even more relevant comparisons.
Clear Lake Sporting Goods is also technically a retail store, albeit a specialized one. An analyst might also consider the industry averages for general or online retail of 20.64% and 27.05%, respectively. Compared to the broader retail industry, Clear Lake Sporting Goods is still performing well, but its performance is not as disparate to industry average as when compared to recreational products (see Table 6.1).
| Industry | ROE (%) |
| Advertising | 2.93 |
| Air Transportation | −47.03 |
| Computer Services | 13.50 |
| Banking | 8.22 |
| Financial Services (nonbanking) | 64.28 |
| Food Processing | 10.12 |
| Renewable Energy | −20.59 |
| Hospitals/Health Care Facilities | 70.64 |
| Hotels/Gaming | −30.40 |
| Publishers | −14.18 |
| Recreational Products | 12.56 |
| Real Estate (general) | 2.00 |
| Retail: | 0.00 |
| Automotive | 36.28 |
| Building Supply | 0.27 |
| General | 20.64 |
| Grocery | 30.63 |
| Online | 27.05 |
| Rubber and Tires | −26.69 |
| Shoes | 23.70 |
| Software (systems and applications) | 28.09 |
| Transportation | 21.47 |
| Total Market Average | 8.25 |
Table 6.1 Return on Equity by Industry in 2020 It’s important to look at any ratio in context of the organization, its history, and the industry. (data source: Aswath Damodaran Online)
FAQs
In the 3-step DuPont model – the simpler version between the two approaches – the return on equity (ROE) is broken into three ratio components: Net Profit Margin = Net Income ÷ Revenue. Asset Turnover = Revenue ÷ Average Total Assets. Financial Leverage Ratio = Average Total Assets ÷ Average Shareholders Equity.
What are the three basic ratios used in the DuPont system of analysis? ›
The Three-Step DuPont Calculation
We have ROE broken down into net profit margin (how much profit the company gets out of its revenues), asset turnover (how effectively the company makes use of its assets) and equity multiplier (a measure of how much the company is leveraged).
What are the 4 common profitability ratio? ›
Common profitability ratios include gross margin, operating margin, return on assets, return on sales, return on equity and return on investment.
What is the DuPont theory of financial analysis? ›
DuPont analysis is a useful technique used to decompose the different drivers of return on equity. An investor can use analysis tools like this to compare the operational efficiency of two similar firms. Managers can use DuPont analysis to identify strengths or weaknesses that should be addressed.
What is the DuPont 5 formula? ›
5-Step DuPont Analysis Formula
Tax Burden = Net Income / Pre-Tax Income. Asset Turnover = Revenue / Average Total Assets. Financial Leverage Ratio = Average Total Assets / Average Shareholders' Equity. Interest Burden = Pre-Tax Income / Operating Income.
What is the DuPont rule? ›
Law 10.7bi states that “an offside player can be put onside when an opponent of that player carries the ball five metres,” which has led to strange kicking stalemates with a legion of players camped in the middle of the field waiting to be put onside by their opponent.
How to solve profitability ratio? ›
How to calculate the net profitability ratio
- Calculate net profit and net sales. The net profitability ratio formula divides the net profit by net sales. ...
- Divide net profit by net sales. Next, divide the net profit by the net sales using the totals you have. ...
- Multiply by 100 to get the net profit ratio.
As a rule of thumb, a good operating profitability ratio is anything greater than 1.5 percent. The industry average for most countries around the world hovers closer to 2 percent. A good net income ratio hovers around 5 percent.
How to calculate profitability? ›
The simplest measure of profitability is net income, which is revenue minus expenses. This shows the amount of income you generate from your business after accounting for all expenses.
Is DuPont analysis good or bad? ›
While the DuPont analysis model can be a very helpful tool for investors, it is not without its weaknesses. The expansive nature of the DuPont analysis means that it requires several inputs. As with any calculation, the results are only as good as the accuracy of the inputs.
DuPont Analysis helps in assessing a company's performance by providing an understanding of factors contributing to its return on equity. It also identifies areas where a business is doing well or requires improvement, influencing the firm's strategic and financial planning.
What is the DuPont process? ›
A heavy-liquid minerals separation process in which organic liquids of high specific gravity, known as parting liquids, are used. With sp gr 1.00 to 2.96 and very low viscosities, they serve ideally for the medium in the sink-and-float separation of solid materials.
What does the DuPont identity tell you? ›
The DuPont identity is an expression that shows a company's return on equity (ROE) can be represented as a product of three other ratios: the profit margin, the total asset turnover, and the equity multiplier.
What is the profitability ratio analysis? ›
Profitability ratios are a type of accounting ratio that helps in determining the financial performance of business at the end of an accounting period. Profitability ratios show how well a company is able to make profits from its operations.
Do you want a high or low DuPont ratio? ›
Generally, the higher the ratio, the better. It should be noted that, in order to generate more sales, management might reduce the net profit by reducing prices. Lowest-cost firms (like Wal-Mart) have used this strategy very effectively.
What is DuPont control chart in ratio analysis? ›
The Du Pont Chart helps management to identify the areas of problems, which affect profit, In other words, management can easily visualize the different forces affecting profits, and profits could be improved either by putting capital into effective use, which will result in higher turnover ratio, or by better sales ...
