You are on page 1of 2

DuPont Ratio: The accountants working with global chemical giant, DuPont, from where it derives its name,

developed this ratio. The profitability of any investment in business has been measured by the ratio of returns on Equity Profits ROE = Total Shareholders Equity It indicates the % return that a business gets from Shareholders Equity. In DuPont ratio, the ratio of ROE was split into three as follows:

Profits

Sales

Total Asset Equity

ROA

= -------------Sales

-------------- X --------------Total Assets

The first bloc in DuPont ratio, i.e., the ratio of profits to sales represents the profitability of businesss operation. It reflects margins for the business. The second ratio represents the number of times the assets of a business are turned over in its sales. Asset turnover also reflects the volumes of sales of a business. The third ratio represents the contribution of share holders to the total assets. Referred to as leverage this ratio indicates the shareholders stake in the business. If large part of the business is financed by shareholders funds, the business has low gearing. If the business has been financed more by debt, the business is highly geared. The ROE is thus dependent on three variables, margins, volumes and leverage. The profit function can be written as follows.

ROE = fn {Margin, Volume. Leverage}


Dupont ratio has provided a significant insight in nature and conduct of many businesses. Its simplistic approach has helped define many strategies for business management.

The strategic choice for businesses often boils down to a decision between margins vs. volume. Considering the nature of business, either the business is called on to sacrifice

margin for the sake of volume. Often volumes are sacrificed to preserve the margin. In trade, it is customary to go for volumes, in industry on margin. Study of secular trend in margin and asset turnover of an industry or a business reveals the strategic thrust. The margin or volume based strategy is reflected in the movement in ROA (Return on Assets). When competitive environment puts pressure on a companys margins, the same is often reflected in reducing ROA. Leverage by indicating mode of financing sharpens the strategic thrust. Since debt is less expensive mode of financing than equity, highly geared firms are often highly profitability. By their very nature, highly geared firms are vulnerable to the larger business environment. In good times, these companies have high ROE and give huge rewards to their share holders. In bad times, these companies with large debt finance become vulnerable and often fail. The investment banking firms like Lehman Brothers of Bear Stern were highly geared and with pressure on profitability in the wake of sub-prime crisis, they suffered severe liquidity crunch and had to opt for liquidation. The DuPont ratio also validates the PIMS survey, which found that the capital intensity was negative influence on the profitability of a business. Taking the second bloc above capital intensity, the total assets in the denominator, drags downwards the asset turnover ratio. This reduction necessitates to be balanced by increased margins. In competitive markets, when the margins are under pressure, the highly capital intensive businesses suffer. It is also apparent that high total asset base may also be due to high working capital component. If businesses pile up large inventories and/or receivables, they reduce the asset turn over and cause reduced ROE for the businesses.