Dupon's formula - calculation example

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

The Dupont model is considered one of the most effective methods of factor analysis. It was proposed back in 1919 by specialists of the company of the same name. At that time, profitability indicators of asset turnover and sales were widely disseminated. It was in this model that these indicators were considered together for the first time, while the model had a triangular structure.

The Dupont formula is often used, factor analysis with its help is extremely simple. At the top of the triangle is a coefficient indicating the return on total capital, it is the main indicator in this scheme, which means the profit from the funds invested in the company. Below are indicators of the factor type, namely the amount of profit (sales profitability) and asset turnover. The DuPont formula means that the return on investment will be equal to the product of sales profit and current assets.

Dupon model

The main goal of the DuPont model is to identify factors that can determine business performance, to assess the degree of influence of these factors on development trends, taking into account their changes andsignificance.

It is mainly used to assess risks, and this applies to both the capital used to develop the organization and investing in other projects. Below we consider the main indicators of the model.

Return on equity of the company

In order for the owners to get a return on investment, they need to make contributions to the authorized capital. The calculations shown by the DuPont formula say that for this they have to sacrifice the funds that form the capital of the company, but at the same time they are en titled to a share of the profits received by the organization. It is beneficial for them that it is displayed on their own capital, thus forming an important process for shareholders. But the application of this model entails the introduction of restrictions. Real income can only be obtained from sales, while assets do not bring profit. Based on this indicator, it is impossible to evaluate the business units of the company. It is also worth considering the fact that companies are mostly leveraged.

For factor analysis, the Dupont formula plays an important role: an example, if we consider the banking business, as borrowed capital is the basis for building a business. This means that in fact the bank's operations are carried out at the expense of attracted deposits, and the role of equity capital is reserve savings, in other words, a guarantee that the bank is able to maintain its liquidity. That isthe metric in question can only answer questions related to the equity that an organization earns for auctioneers.

Asset turnover processes

Asset turnover is an indicator that reflects the number of turnovers of capital invested in the organization's assets over a certain period of time. In other words, it is an assessment of the intensity of exploitation of all assets, and there is no difference through what sources they were formed. It is also able to show how much revenue the company has from the money invested in assets.

Sales profitability

If the DuPont formula is taken as the main factor in the calculation, this indicator is used as the main indicator by which the effectiveness of an organization is assessed, which does not have too large savings of its own capital and fixed assets. In fact, if the value of the denominator is low during the calculations, it turns out that the financial potential of the company is overestimated by obtaining too high a return on equity. With such an approach, it is possible to objectively assess the current state of affairs of the company.

Also, through the return on sales indicator, it is clearly visible how much the company received net profit from the amount of the unit sold. If the DuPont formula is used, this indicator allows you to calculate the amount of net income that the organization will have after it covers the cost of the product, pays all taxes and interest onloans. This indicator reveals important aspects, namely the sale of products and the share of funds spent on obtaining them.

Return on assets. DuPont formula

This indicator reflects the efficiency of the company's operations. It is used as the main production indicator that can reflect the efficiency of work with invested capital. Based on this, we note that the profitability of total assets can be determined by two factors - profit and turnover. Together, this creates a multiplicative model used in financial statements.

Financial leverage

Financial leverage is necessary in order to correlate debt and equity, as well as to show its impact on the net profit of the enterprise. It is worth noting that the higher the share of loans, the lower the net profit will be, since the amount of interest costs will increase. If a company has a high percentage of loans, it is called dependent. Conversely, an organization that does not have debt capital is considered financially independent.

Thus, the role of financial leverage is to determine the stability and riskiness of a business, as well as a tool for evaluating the effectiveness of working with loans. It should be borne in mind that the return on equity is directly dependent on leverage.

Dupon model (formula):

ROE=NPM TAT

The difference between the return on total assets and the cost of the loan is equal to the differentialfinancial leverage.

The ratio of interest expense to debt capital, including taxes, is equal to the cost of debt capital.

Because financial leverage can increase return on equity, it also increases shareholder value. This is evidenced by the Dupont formula, an example of the calculation of which is represented by financial leverage. Thanks to this, it is possible to optimize the structure of assets. It is worth noting that additional capital increases should be carried out as long as the leverage remains positive. And it will become negative as soon as the cost of the loan exceeds the return on equity. Dupont's formula clearly shows the significance of this indicator. It is also worth remembering at the same time about financial stability, if the number of debts exceeds the required threshold, the company will face bankruptcy.

Loan use limit

To define this boundary, the DuPont formula shows that the difference between equity and the amount of illiquid, fixed assets must be positive. Based on the obtained values, you can build an enterprise policy. For the indicator of profitability of sales - accounting for pricing policy, control of cost management, optimization of sales volumes and much more.

Asset turnover will affect asset management, credit policy and inventory management. The capital structure will affect all areas of investment and taxes.

General assessment

Return on equity serves as a measure of performancefinancial management. This value directly depends on the decisions made regarding the main areas of the company's activities. If this indicator changes, it means that the efficiency of the business is growing or falling. Through the return on assets, you can track the effectiveness of working with investment capital, since it is the link between the main and financial activities, as well as between sales and assets.

Efficiency in core business management

To assess the effectiveness of core business management, the indicator of return on sales is used. This indicator can change both under the influence of external factors and taking into account the internal needs of the company.

As an example, consider the change in profitability taking into account various factors in more detail:

• Profitability of sales may increase given that the rate of revenue will be faster than the rate of costs, this situation may occur if the volume of sales has increased or their assortment has changed. This is a positive development trend for the company.
• Costs are dropping faster than revenue. This situation may arise in the event of an increase in product prices or a change in the sales structure. In this case, the profitability indicator grows, but the volume of revenue decreases, which, of course, will not have a very positive effect on the development of the company.

• There is an increase in revenue and a decrease in costs, this situation can be simulated by increased prices,change in assortment or cost rates.
• Costs are rising faster than revenue. The reason may be inflation, lower prices, higher costs, changes in the structure of sales. The situation is bad enough that pricing analysis is needed.
• Revenues are declining faster than costs, this can only be affected by sales cuts. Marketing policy analysis is important here.