Du Point Analysis

Manager and investors are concerned with the return on common stockholder’s equity (ROE). An important linkage between ROE and three other ratios has been called Du Pont Analysis, named for the large chemical company that popularized its use. ROE can be expressed as the product of three other ratios, the net profit margin, the total asset turnover and the equity multiplier.

Return on equity= (Net profit margin)(Total asset turnover)(Equity multiplier)-------------------------(1)

This relationship can be seen by noting that the components of the middle ratio cancel out the denominator and numerator, respectively of the first and third ratios. That leaves the left side of the equation.

Net income/Stockholders equity=(Net income/Sales)(Sales/Total assets)(Total assets/Stockholders equity)

Changes in ROE can be traced to changes in the net profit margin, total asset turnover, or equity multiplier. This relationship helps diagnose problems and assists managers in deciding where improvements must occur to improve the company's ROE.

Du Point Analysis chart for Anheuser-Busch.

Of course, a company would like to have a high net profit margin, a high total asset turnover and a high equity multiplier, which would result in an extremely high ROE. Unfortunately, there is usually a trade off between the various parts of the DuPont System. For example, companies with high turnovers usually have low profit margins and vice versa. In addition, companies with a low return on assets (which is the net profit margin times the total asset turnover) sometimes have high equity multiplier, which gives them a more normal (competitive) ROE.

Below table illustrates this trade off among industries. The total asset turnover is largely determined by the production and marketing processes in each particular industry. For example, it's not possible to generate electricity without a large investment in plant and equipment. Similarly, banks must invest heavily in loans and jewelers must maintain very expensive inventories. Total asset turnover rates for electric companies, jewelry stores and commercial banks, then are relatively low compared to restaurants.
You can see in table below that net profit margin and total asset turnover tend to be inversely related. Similarly, companies with a low ROA sometimes have a high equity multiplier. Such trade offs are in part because profit margins are competitively determined in the marketplace for the goods and services the companies are supplying. Restaurants, for example, operate on lower profit margins than electric companies, jewelers, or banks. Finally, even the amount of leverage a company chooses is influenced by the industry's risk and its ROA, which tends to further enforce these patterns.