The cause of effect

By comparing a company’s ROE to the industry’s average, something may be pinpointed about
the company’s competitive advantage. In contrast, a declining ROE can mean that management
is making poor decisions on reinvesting capital in unproductive assets. From the DuPont analysis
model, companies get a more comprehensive picture of a company’s fundamental performance.
ROE may also provide insight into how the company management is using financing from equity
to grow the business. A sustainable and increasing ROE over time can mean a company is good
at generating shareholder value because it knows how to reinvest its earnings wisely, so as to
increase productivity and profits.Derived from the ROE ratio, the DuPont analysis framework
breaks down the ratio into three components: the net profit margin, total asset turnover and
financial leverage. From this more detailed analysis, companies and investors can better know
what a company’s strengths and areas of opportunity are.
The Bottom Line
The most notable pro of DuPont analysis is how it provides businesses and investors with greater
clarity on why a company is performing how it is. Each of the components of the DuPont model
can tell investors more about what’s driving a company’s return on equity ratio. For example, if a
company’s financial leverage is higher than that of a similar company, it could be a sign to the
investor that the first company would be a bigger risk.As for the most significant con of the
formula, perhaps the reliability of data. Because it’s a more comprehensive decomposition of the
simpler ROE formula, the DuPont framework requires a lot more data. This data needs to be
accurate, and given how business numbers can fluctuate, this can lead to possible discrepancies
when analyzing.Also, it’s important again to remember that DuPont analyses should be
compared for similar companies to account for any differences that may result from disparate
industries and standards.
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