Financial Leverage Ratio = Average Total Assets ÷ Average Shareholders’ Equity.Tax Burden = Net Income ÷ Pre-Tax Income.The five components of the 5-step DuPont formula are the following ratios: The company must strike the right balance between benefiting from debt financing but not placing excess leverage on the company, where the company’s cash flows are insufficient to handle all the debt obligations and are now at risk of default.Often called the “equity multiplier,” increasing the amount of debt to benefit from the lower taxes, the lower cost of capital, and obtaining access to a cheaper funding source could easily backfire from irresponsible decision-making – hence, the company must be led by a management team with their interests aligned with that of its shareholders.However, interest expense is tax-deductible and creates a “tax shield” that reduces the amount of taxable income (EBT).The greater the reliance on debt financing, the higher the periodic interest expense owed to the lender, which causes the risk of default to rise.The third and final component, financial leverage, refers to the total amount of debt in the company’s capital structure.What are the DuPont Analysis Ratio Components?įinancial Leverage Ratio = Average Total Assets ÷ Average Shareholders Equity Efficiently Utilizes Assets to Generate More Revenue.The DuPont analysis implies that a company can increase its ROE if it: Upon splitting up the return on equity (ROE) calculation into these three components, the changes in ROE can be better understood and what is driving the net increase (or decrease). The 3-step DuPont formula shown below is the most commonly used equation: If we multiply the ROE formula above by two ratios – “Revenue ÷ Revenue” and “Average Total Assets ÷ Average Total Assets” – we are essentially multiplying the ROE by one, since the numerator and denominator are the same in both ratios.īut with some rearranging of the terms, we arrive at the three standard ratios mentioned earlier: Return on Equity (ROE) = Net Income ÷ Average Shareholders’ Equity The starting point to arrive at these three components is the return on equity (ROE) formula. Financial Leverage Ratio = Average Total Assets ÷ Average Shareholders Equity.Asset Turnover = Revenue ÷ Average Total Assets.Net Profit Margin = Net Income ÷ Revenue.In a 3-step DuPont analysis, the equation states that if a company’s net profit margin, asset turnover, and financial leverage are multiplied, you will arrive at the company’s return on equity (ROE).Īs the simpler version between the two approaches, the return on equity (ROE) is broken into three ratio components: Originally devised in the 1920s by Donaldson Brown at DuPont Corporation, the chemical company, the model is used to analyze the return on equity (ROE) as broken down into different parts in order to analyze the contribution of each part. DuPont Analysis is a framework used to break apart the underlying ratio components of the return on equity (ROE) metric to determine the strengths and weaknesses of a company.
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