The purpose of a profitability analysis is to evaluate overall business efficiency and performance. Dupont analysis and several common measures of profitability are frequently used to evaluate overall business efficiency and performance.
The ultimate goal of any business is to generate a sustainable profit. Thus, owners and managers pay special attention to a business's performance and efficiency. Profitability analysis provides an opportunity for both business owners and managers to evaluate the ability of a business to generate profit in the future. To successfully analyze business profitability, both the income statement and the balance sheet are required. In addition to Dupont analysis, there are six common profitability measures used to assess a business's profitability and ability to return profits to investors: asset turnover, return on total assets, return on stockholders' equity, earnings per share (EPS), price-earnings (P/E) ratio, and dividends per share.
Dupont analysis breaks down return on equity (ROE) into three basic areas to better understand organizational performance: asset usage, financial leverage, and operational efficiency. ROE is calculated using metrics from each of the three areas: ROE=Asset Turnover×Profit Margin×Financial Leverage. By breaking down ROE into smaller sections, it can be easier to identify which elements of organizational performance are driving changes in ROE over time. Asset turnover measures how well the organization is utilizing assets to generate sales. Profit margin, or return on sales (ROS), measures how much of each sales dollar results in profit after all expenses are covered. Finally, financial leverage measures how much of an organization's assets come from equity versus debt. Combining three areas into one analysis helps give investors a well-rounded view of factors that impact an organization's overall return on equity.
Created to measure the effectiveness of a business's asset utilization to generate revenue, the asset turnover ratio can be computed by dividing the net sales by the average total assets. To compute the asset turnover ratio, both the comparative balance sheet and the income statement are needed. The comparative balance sheet provides a 2-year comparison of assets, liabilities, and equity. Net sales are the total sales less any sales discounts or sales returns and allowances, which is the same as net sales or net revenue that is reported on the income statement. The average total assets can be computed by adding the assets for the past 2 years and dividing by two. To illustrate the computation of the asset turnover ratio for 2017, Greenfield Gates Company has provided information from its income statement and balance sheet: 2017 net sales at $905,000 and total assets at $780,000, 2016 net sales at $900,000 and total assets at $650,000. Their asset turnover is 1.27 which means that on average, their net sales would pay for or replace their total assets 1.27 times per year.