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6.6 Profitability Ratios and the DuPont Method

3 min readLast Updated on June 18, 2024

Profitability ratios are key tools for assessing a company's financial health. They measure how effectively a business turns sales into profits, using metrics like profit margins and return ratios. These ratios help investors and managers gauge a company's efficiency in generating income from its operations.

The DuPont analysis takes a deeper dive into return on equity (ROE). By breaking ROE into profit margin, asset turnover, and financial leverage components, it reveals the underlying drivers of a company's profitability. This method helps pinpoint areas for improvement in a firm's financial performance.

Profitability Ratios

Profit margin calculation and interpretation

Top images from around the web for Profit margin calculation and interpretation
Top images from around the web for Profit margin calculation and interpretation
  • Measures percentage of each sales dollar resulting in profit
  • Net income divided by sales: Profit Margin=Net IncomeSales\text{Profit Margin} = \frac{\text{Net Income}}{\text{Sales}}
    • Higher margins indicate greater profitability and efficiency (Apple, Coca-Cola)
  • Gross profit margin focuses on gross profit relative to sales
    • Gross profit divided by sales: Gross Profit Margin=Gross ProfitSales\text{Gross Profit Margin} = \frac{\text{Gross Profit}}{\text{Sales}}
    • Percentage of each sales dollar remaining after cost of goods sold (retail, manufacturing)
  • Operating profit margin considers operating income relative to sales
    • Operating income divided by sales: Operating Profit Margin=Operating IncomeSales\text{Operating Profit Margin} = \frac{\text{Operating Income}}{\text{Sales}}
    • Percentage of each sales dollar left after cost of goods sold and operating expenses (utilities, rent)
    • Can be calculated using earnings before interest and taxes (EBIT) for a more comprehensive view
  • Net profit margin most comprehensive, considering net income relative to sales
    • Net income divided by sales: Net Profit Margin=Net IncomeSales\text{Net Profit Margin} = \frac{\text{Net Income}}{\text{Sales}}
    • Percentage of each sales dollar remaining as profit after all expenses and income (Amazon, ExxonMobil)

Return ratios for financial efficiency

  • Return on total assets (ROA) measures efficiency of assets in generating profits
    • Net income divided by average total assets: ROA=Net IncomeAverage Total Assets\text{ROA} = \frac{\text{Net Income}}{\text{Average Total Assets}}
    • Higher ROA indicates more efficient asset utilization (Walmart, McDonald's)
  • Return on equity (ROE) measures return generated on shareholders' equity
    • Net income divided by average shareholders' equity: ROE=Net IncomeAverage Shareholders’ Equity\text{ROE} = \frac{\text{Net Income}}{\text{Average Shareholders' Equity}}
    • Higher ROE suggests greater efficiency in generating shareholder returns (Microsoft, JPMorgan Chase)
  • ROA and ROE evaluate overall financial efficiency and performance
    • ROA focuses on efficiency of asset utilization
    • ROE emphasizes return generated for shareholders on invested capital (dividends, stock price appreciation)
  • Return on investment (ROI) measures the profitability of an investment relative to its cost

Additional Financial Ratios

  • Liquidity ratios assess a company's ability to meet short-term obligations
  • Solvency ratios evaluate a company's long-term financial stability and ability to meet debt obligations
  • Operating leverage measures the degree to which a company can increase operating income by increasing revenue

DuPont Analysis

DuPont analysis of return on equity

  • Breaks down return on equity (ROE) into three components:
    1. Profit margin
    2. Asset turnover
    3. Financial leverage
  • ROE=Profit Margin×Asset Turnover×Financial Leverage\text{ROE} = \text{Profit Margin} \times \text{Asset Turnover} \times \text{Financial Leverage}
  • Profit margin measures profitability of sales
    • Net income divided by sales (percentage of sales resulting in profit)
  • Asset turnover measures efficiency of asset utilization
    • Sales divided by average total assets (effectiveness of generating sales from asset base)
  • Financial leverage ratio of average total assets to average shareholders' equity
    • Extent of reliance on debt financing relative to equity financing (debt-to-equity ratio)
  • Allows deeper analysis of factors contributing to ROE
    • Identifies if ROE driven by profitability, efficiency, or leverage
    • Pinpoints areas of strength or weakness in financial performance (margins, turnover, debt levels)
  • Changes in any of the three components impact overall ROE
    • Improving margins, increasing turnover, or using more leverage can increase ROE
    • Excessive leverage also increases financial risk and potential instability (bankruptcy, default)
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© 2025 Fiveable Inc. All rights reserved.
AP® and SAT® are trademarks registered by the College Board, which is not affiliated with, and does not endorse this website.

© 2025 Fiveable Inc. All rights reserved.
AP® and SAT® are trademarks registered by the College Board, which is not affiliated with, and does not endorse this website.
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