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Two florists, Flowers by Helene and Hector Florist, operate in the same market and are the same size. Both companies earn a return of 13% on equity. The following table shows their respective net profit margins, asset turnover rates and financial leverage, an indicator of bank debt.
|Flowers by Helene||Hector Florist|
|Net profit margin||10%||10%|
Although both the companies have a return on equity of 13 percent, their underlying strengths and weaknesses are quite different. Hector Florist does a better job in using assets to generate revenues. But, it is unable to transform this advantage into higher return on equity. Flowers by Helene can improve profits by using its total assets more effectively in generating sales. Hector Florist can generate more revenue by raising some debt.
Using the DuPont analysis to measure a business’ return on equity provides two important results: an important indicator of company-wide financial performance and insight into company operations. Named for the chemical company that first used it, the analysis is a multi-step calculation, which reveal a company’s financial strengths and weaknesses.
The Du Pont formula enables analysts to determine which of the elements is dominant in any change of ROE. It enables head-to-head company comparisons. And, when used with trend data, the ratio can also be used for internal, period-on-period analysis of company performance.
This ratio can be calculated in two ways. The three-factor analysis uses net profit margin, asset turnover and financial leverage to measure ROE. This is the three-factor formula:
Return on Equity = Net profit margin × asset turnover × financial leverage = (net income / sales) × (sales / total assets) × (total assets / total equity)
However, the equation can be extended into five factors, which provide deeper insight into company operations.
Specific values, which indicate operational strengths or weaknesses, will vary a lot by industry. Certain types of retail operations, particularly stores, may have very low profit margins on sales, and relatively moderate leverage. In contrast, low-margin groceries may have very high turnover, selling a significant multiple of their assets per year. Other industries, such as fashion, may derive a substantial portion of their competitive advantage from selling at a higher margin, rather than higher sales volume.