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One of the easiest ways to gauge whether a company is an asset creator or a cash consumer is to look at the return on equity (ROE). In its simplest form, ROE is calculated by dividing one year's earnings by shareholder's equity. Businesses that generate high returns on equity are businesses that create substantial assets for each dollar invested.
The Dupont Analysis is a means of analyzing the three components of return on equity:
- Net Margin = Net Income / Sales. How much profit a company makes for every $1.00 it generates in revenue. The higher a company’s profit margin the better.
- Asset Turnover = Sales / Total Assets. The amount of sales generated for every dollar's worth of assets. This measures the firm's efficiency at using assets. The higher the number the better.
- Leverage Factor = Total Assets / Shareholder's Equity. The higher the number, the more debt the company has.
The Dupont Analysis looks like this:
As an example, let's take XYZ Company's financials (in thousands):
Net Income = $2,592
Sales = $21,244
Assets = $132,616
Equity = $9,744
XYZ's Net Margin = $2,592 / $21,244 = .122 (12.2%)
XYZ's Asset Turnover = $21,244 / $132,616 = .16
XYZ's Leverage Factor = $132,616 / $9,744 = 13.6
XYZ ROE = .122 x .16 x 13.6 = .2656 = 26.6%
For every dollar invested, XYZ Company creates 26.6 cents in assets.
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