How does the dupont system break down return on assets?

Answer 1

The Du Pont System The returns on investment ratios give us a "bottom line" on the performance of a company, but don't tell us anything about the "why" behind this performance. For an understanding of the "why," the analyst must dig a bit deeper into the financial statements. A method that is useful in examining the source of performance is the Du Pont system. The DuPont system is a method of breaking down return ratios into their components to determine which areas are responsible for a firm's performance. To see how it's used, let's take a closer look at the first definition of the return on assets: Basic Earning Power =EBIT / Total Assets Suppose the return on assets changes from 20% in one period to 10% the next period. We do not know whether this decreased return is due to a less efficient use of the firm's assets-that is, lower activity-or to less effective management of expenses (i.e., lower profit margins). A lower return on assets could be due to lower activity, lower margins, or both. Because we are interested in evaluating past operating performance to evaluate different aspects of the management of the firm and to predict future performance, knowing the source of these returns is valuable. Let's take a closer look at the return on assets and break it down into its components: measures of activity and profit margin. We do this by relating both the numerator and the denominator to sales activity. Divide both the numerator and the denominator of the basic earning power by sales: Basic Earning power = (EBIT / Sales)(Sales/Total Assets) This says that the earning power of the company is related to profitability (in this case, operating profit) and a measure of activity (total asset turnover). Basic earning power = (Operating profit margin) (Total asset turnover) If we are analyzing a change in basic earning power, we therefore know that we could look at this breakdown to see the change in its components: operating profit margin and total asset turnover. This method of analyzing return ratios in terms of profit margin and turnover ratios, referred to as the Du Pont System, is credited to the E.I. Du Pont Corporation, whose management developed a system of breaking down return ratios into their components.