5-step DuPont

Firstly, here’s the equation for ROE using 3-step Dupont identity, based on that, the
5-step Dupont is developed:

We will separate net income like this. We all know EBT is earnings before tax, and
when we subtract taxes, we get net income. Therefore, Net Income can be broken
down into EBT multiplied by the term (1-tax rate).

After that, we replace Net Income in the original formula with the 2 components that
we have separated from Net Income above. I will place the term (1-tax rate) on the
outermost side. Here, we get a new formula, with the appearance of EBT and tax rate.

Then, I continue to separate EBT into EBIT minus Interest Expense. Since EBIT is
earnings before interest and tax, it makes complete sense to write EBT as EBIT -
Interest Expense.

We continue to replace EBT in the formula by the expression we’ve done before

When we multiply the Sales over Assets expression into the expression we just
replaced, We end up with the final five-step DuPont equation. Where EBIT/Sales is
Operating profit margin,...

Note that, asset and shareholder's equity in this formula are taken as average
values. I will provide a clearer example later.

I have one example to make you deeply understand.

Suppose we want to calculate the ROE for Company A. The following information can
be found in the company's financial statements:
I’ve said before that asset and shareholder's equity in this formula are taken as
average values. Here we have the beginning and ending values of each, so we take the
average of the 2 values for asset and equity.
Plugging this information into the 5-step DuPont formula, we can get this equation.
From there, we can calculate the ROE for company A is 7.5%.
From the analysis, we can gather some information that:
- The operating margin is 20%. This indicates that the company has a relatively
healthy operating margin.
- The asset turnover ratio is approximately 0.56. This means that for every dollar
invested in assets, the company generates 56 cents in sales. An asset turnover
of 0.56 is considered moderate, and the effectiveness of this can vary greatly
depending on the industry. For capital-intensive industries, this might be
acceptable, while for others, it might suggest less efficient use of assets.
- The interest burden equals 0.8 or 80%. This shows that after paying interest
expenses, the company retains 80% of its operating income. A high interest
burden can reduce the amount of operating income available to pay taxes and
return to shareholders.
- The financial leverage ratio is approximately 1.125. This indicates that the
company is using a moderate amount of debt to finance its assets, suggesting
that the company is not overly reliant on debt.
- The tax retention rate is 75%. This means the company gets to keep 75% of its
earnings before taxes. A reasonable tax rate, which doesn't excessively
diminish the net income.

That information helps managers as well as investors have a clearer view of the
company's operational efficiency, and identify specific areas of strength and weakness.
Thereby, managers can use the insights from the DuPont analysis to make informed
strategic decisions, such as investing in areas that will increase asset turnover or
reduce financial leverage. Also, by understanding the components of ROE, investors
can make more informed decisions about growth opportunities of a company.