A deeper look at the DuPont framework’s three components

- The return on equity number can be decomposed into three components, profitability, efficiency, and leverage. We also call this the DuPont framework, which is a formula that lays these three ratios out in a very systematic fashion. Let's again use balance sheet and income statement numbers for two hypothetical companies. Uncertain and Benchmark. As we saw in the previous module, Uncertain has a return on equity of 9.3%, and Benchmark had a return on equity of 20.3%. The 9.3% return on equity is low, especially when compared to the 20.3% return on equity Benchmark. We can use this DuPont framework to reveal why Uncertain's ROE is low. The DuPont framework is constructed on the idea that return on equity is composed of three distinct components, profitability, efficiency, and leverage. The leverage measure tells us how much money we have borrowed to leverage the initial equity investment, and thus buy more assets. Why do we buy assets? We buy assets to generate sales. The second component of the DuPont framework is a measure of how efficiently we use our assets to generate sales. The more sales we can generate per dollar of assets, the better. The third component of the DuPont framework is profitability. How well do we control our expenses to squeeze as much profit as possible out of each dollar of sales? Here are the three ratios that comprise the DuPont framework. First profitability, we measure that with the profit margin, which is net income divided by sales. For efficiency, we measure that with asset turnover. That's sales divided by assets. And for leverage, that ratios assets to equity. That's assets divided by equity. Profit margin is the number of dollars in profit for every $100 in sales. Profit margin is also called return on sales. This is a measure of a company's profitability. Asset turnover is the number of dollars in sales generated each year from each dollar of assets. This is a measure of a company's efficiency in using its assets to generate sales. Now, asset to equity is the number of dollars of assets purchased for each dollar of owner investment in the company. Now, the way to cause this ratio to be more than one is to augment owner invested funds with borrowed money. The assets to equity ratio is a measure of financial leverage. Now, let's take a look at Uncertain versus Benchmark, using the DuPont framework to identify why Uncertain has performed poorly relative to Benchmark. We first noticed that leverage is roughly the same for both companies. So the ROE difference between Uncertain and Benchmark is not the result of a difference in leverage. Looking at the efficiency measure, we see that Uncertain generates a $1.38 in sales for every dollar in assets, compared to Benchmark, which generates a $1.70 in sales for every dollar in assets. In short, Uncertain is generating fewer sales from each dollar in assets. Uncertain has an excess amount of one or more assets. Now, when it comes to profitability, Uncertain is generating only $3.50 cents in profit for $100 in sales compared to Benchmark, which is generating $6.20 in profit, for every $100 in sales. Uncertain has one or more expenses, which are too high relative to its level of sales. The DuPont framework tells us that Uncertain company's ROE is low because of both profitability, some expenses are too high, given the level of sales, and efficiency, some assets are too high given the level of sales. Now, do we have any other questions? Absolutely. When it comes to efficiency, which specific assets are being used inefficiently by Uncertain? With respect to profitability, which specific expenses are too high? Using common size financial statements, we could quickly discover that Uncertain is spending too much on wage expense and R&D expense, and is holding too much accounts receivable, and property plant equipment. Ah, but alas, the study of common sized financial statements is just outside the scope of this course, but we cover this in detail in our Corporate Financial Statement Analysis course, right here in the LinkedIn Learning Library.