Du Pont System

An expression that breaks return on equity (ROE) down into three parts: profit margin, total asset turnover and financial leverage.

The Du Pont identity tells us that ROE is affected by three things:

-Operating efficiency (as measured by profit margin)
-Asset use efficiency (as measured by total asset turnover)
-Financial leverage (as measured by the equity multiplier)

ROE = Profit Margin (Profit/Sales) * Total Asset Turnover (Sales/Assets) * Equity Multiplier (Assets/Equity)

Ie. ROE = (Net Income/Sales)*(Sales/Total Assets)*(Total Assets/Total Equity)

=>

If ROE is unsatisfactory, the Du Pont identity helps locate the part of the business that is underperforming.

Here is how the DuPont identity is derived:

ROE = NI/TE
Multiply by 1 (TA/TA) and then rearrange
ROE = (NI / TE) (TA / TA)
ROE = (NI / TA) (TA / TE) = ROA * EM
Multiply by 1(S/S) and then rearrange
ROE = (NI / TA) (TA / TE) (S/S)
ROE = (NI / S) (S / TA) (TA / TE)
ROE = PM * TAT * EM
ROE = Profit Margin * Total Asset Turnover * Equity Multiplier

Where:
ROE = Return on Equity
NI = Net Income
TE = Total Equity
TA = Assets
ROA = Return on Assets
EM = TA/TE = 1 + D/E = The Equity Multiplier
S = Sales