The DuPont financial analysis model
The DuPont model separates finance from operations. It has three primary components:
- Profitability
- Activity
- ROCE – Return on capital employed.
Financial analysis using the DuPont model
| Income statement | Balance sheet | ROCE | ||
|---|---|---|---|---|
| Performance measure is: Profitability |  | Performance measure is: Activity |  | Profitability x Activity |
Commentary on the DuPont model financial components:
Profitability
Profitability is a measure of the efficiency of the income statement.
PROFITABILITY % = Earnings before interest and tax (EBIT) / SALES
The Profitability measurement represents the operating performance of a business entity expressed as a return on sales. It also provides a measurement of operational efficiency in the profit and loss account, void of finance costs.
Activity
Activity is a measure of the efficiency of the balance sheet
ACTIVITY = SALES/TOTAL NET ASSETS
The Activity measurement reflects balance sheet efficiency in terms of the utilization of scarce resources.
ROCE
ROCE is a measure of the return on capital employed.
ROCE = PROFITABILITY x ACTIVITY
ROCE = (EBIT / SALES) x (SALES / TNA)
ROCE = EBIT / TNA
ROCE provides a measurement of the operational return on the investment in total net assets (TNA). This is also the return on net assets (RONA) or the return on investment (ROI) due to the equivalence concept derived from separating finance from operations. ROCE would have to at least equal the average weighted cost of borrowing to avoid reverse leverage taking place. This is the erosion of equity as a result of too little EBIT being generated to service the cost of borrowing.
Limitations of the DuPont model for financial analysis:
- It is a short term measurement.
- It is a before tax measurement.
- Setting a target for a good ROCE is difficult.
- It does not link to the cost of capital.
- It does not link to the time value of money.
- It does not link to value.
Also see: Economic Value Added – EVA®.
Remember when doing your analysis that DuPont is a pre-tax performance analysis tool. It is beneficial to perform the analysis on both a pre-tax and after-tax basis. Strategic Focus includes both.