DuPont System of Analysis

The DuPont System of Analysis merges the income statement and balance sheet into two summary measures of profitability: Return on Assets (ROA) and Return on Equity (ROE). The system uses three financial ratios to express the ROA and ROE: Operating Profit Margin Ratio (OPM), Asset Turnover Ratio (ATR), and Equity Multiplier (EM).


Operating Profit Margin Ratio =

Net Farm Income from Operations + Interest Expense - Value of Unpaid Labor and Management

Divided by

Gross Revenue (Value of Farm Production)


Asset Turnover Ratio =

Gross Revenue (Value of Farm Production)

Divided by

Average Farm Assets


Equity Multiplier =

Average Farm Assets

Divided by

Average Farm Equity


The DuPont System expresses the Return on Assets as:

ROA = OPM * ATR

The Operating Profit Margin Ratio is a measure of operating efficiency and the Asset Turnover Ratio is a measure of asset use efficiency.

The DuPont System expresses the Return on Equity as:

ROE = (ROA - Interest Expense/Average Assets) * EM

The Equity Multiplier is a form of leverage ratio and measures financial efficiency.

 

Figure 1 shows the DuPont Analysis for a farm operation.

Table 1. DuPont Analysis for Two Farms

  Farmer A Farmer B

1. Operating profit margin ratio

0.30

0.12

2. Asset turnover

0.20

0.36

3. ROA (1*2)

0.060

0.043

4. Interest expense to avg. farm assets

0.05

0.03

5. Equity multiplier

2.00

1.50

6. ROE (3-4) * 5

0.02

0.02

Farmer A and Farmer B each have a 2 % ROE. The components of the ratios indicate that the sources of the weakness of the farms are different. Farmer A has a stronger profit margin ratio but lower asset turnover compared to Farmer B. Furthermore, Farmer A has a higher leverage ratio than Farmer B.

The weak ratios for each farm may be decomposed into components to determine the potential sources of the weakness. To improve asset turnover Farmer A needs to increase production efficiency or price levels or reduce current or noncurrent assets. To improve profit margins, Farmer B needs to increase production efficiency or price levels more than costs or reduce costs more than revenue.

The DuPont analysis is an excellent method to determine the strengths and weaknesses of a farm. A low or declining ROE is a signal that there may be a weakness. However, using the analysis you can better determine the source of weakness. Asset management, expense control, production efficiency or marketing could be potential sources of weakness within the farm. Expressing the individual components rather than interpreting ROE itself may identify these weaknesses more readily.