How to Use the DuPont Equation
The DuPont equation was developed by the DuPont Corporation in the 1920s to take a closer look at return on equity by breaking it into its component pieces. Using the DuPont method, return on equity looks like this:
Profit margin x Asset turnover x Equity multiplier = DuPont equation (or return on equity)
If you break down the components in the DuPont method into their respective ratios, the DuPont equation looks like this:
Because net sales appears on top in profit margin and on the bottom in asset turnover, you can cancel it out. The same goes for assets, which you find in both asset turnover and equity multiplier. That leaves you with only net income and equity:
Notice that this simplified version of the DuPont equation is the same as the formula for return on equity. Why not just use the basic return on equity equation?
The full analysis, as you see it in the expanded DuPont equation, provides a full explanation of the factors that influence return on equity to determine exactly how a company could improve its profitability in this respect.
A decrease in net sales, for example, would increase profit margin but make asset management less efficient. If the company can reduce the amount of assets on hand without harming the business, though, the profit margin would increase and the asset efficiency would improve, increasing the value of the company’s equity. Hence, using the DuPont equation can help a company to better manage its profitability.
The equity multiplier is a debt management ratio. You don’t have to be familiar with it to understand how the DuPont equation works or how you can use it, but it looks like this: