How Profitable is a Business? Let's Break it Down with DuPont Analysis

Investors often seek reliable methods to identify fundamentally strong stocks, and DuPont Analysis offers a clear, structured way to do just that. By breaking down Return on Equity (ROE) into profitability, efficiency, and leverage, DuPont helps uncover what truly drives a company's performance. This article guides investors on how to use DuPont Analysis as a stock-picking tool, with real examples from Sun Pharma and Lupin to illustrate the process. 

Let's dive in and uncover the hidden formula behind superior returns! 

What is DuPont analysis?
DuPont analysis is a method that breaks down return on equity (ROE) into its underlying components to explain the drivers behind a company's profitability. 

Formula for ROE:

Let's break down Sun Pharma and Lupin using DuPont Analysis while simultaneously diving deep into each component. 

Return on Equity (ROE)
Return on Equity (ROE) measures how efficiently a company generates profits from shareholders' equity. 

Formula:

ROE tells how efficiently a company uses its equity to generate profits. A higher ROE indicates strong profitability and effective capital management, meaning the company can generate more returns for its shareholders. On the other hand, a lower ROE may signal weak profitability, inefficient use of capital, or a high reliance on debt, which can pose financial risks. 

Following is the calculation of ROE for Sun Pharma and Lupin: 

Sun Pharma has demonstrated a more stable and consistently improving ROE over the years, rising from 5.59% in FY18 to 16.01% in FY24. This steady growth indicates efficient capital utilization and strong profitability, especially with a sharp jump in FY23 and FY24. In contrast, Lupin's ROE has been highly volatile, starting at 1.86% in FY18, dipping into negative territory in FY20 and FY22, and then rebounding strongly to 14.31% in FY24. The fluctuations in Lupin's ROE suggest periods of profitability struggles and capital inefficiencies, whereas Sun Pharma's performance reflects consistent wealth creation. Sun Pharma appears to be a safer and more reliable investment. 

Now, let's understand why Lupin's ROE has struggled over the years with the help of the five components of DuPont Analysis—Net Profit Margin, Tax Efficiency, Asset Turnover, Equity Multiplier and Interest Burden. 

1. Net profit margin
The Net Profit Margin indicates how much profit a company generates from its total revenue. It shows the percentage of revenue that remains as profit after deducting all expenses, including cost of goods sold, operating expenses, interest, and taxes. 

A higher net profit margin suggests strong cost control, efficient operations, and pricing power, while a lower or declining margin may indicate rising costs, competitive pressures, or inefficiencies. 
Formula:

Following is the calculation of Net profit margin for Sun Pharma and Lupin: 

Sun Pharma has consistently maintained a higher net profit margin than Lupin, indicating better profitability and cost efficiency. Over the years, Sun Pharma's net profit margin improved significantly, reaching 19.75% in FY24 from 7.91% in FY18, highlighting strong operational performance and possibly better pricing power or cost control. 

In contrast, Lupin's net profit margin has been volatile, even turning negative in FY20 (-1.75%) and FY22 (-9.31%), indicating periods of financial struggles, possibly due to higher costs, operational inefficiencies, or pricing pressures. However, it has improved in FY24 to 9.57%, signalling a potential recovery. 

Now, let's break down the expanded components of the net profit margin to understand what's driving these differences - Tax burden, Interest burden and operating profit. 

The net profit margin can be further dissected using an extended DuPont analysis, which breaks it down into three key components: tax burden, interest burden, and operating profit margin 

1.1 Tax burden
Tax burden is the proportion of a company's pre-tax profit that it retains after paying taxes. A higher tax burden (closer to 1) indicates lower tax expenses relative to pre-tax income, often due to tax benefits, incentives, or efficient tax planning. On the other hand, a lower tax burden (significantly below 1) suggests that the company is paying a higher proportion of its earnings in taxes, which can reduce overall profitability. 

Following is the calculation of Tax burden for Sun Pharma and Lupin: 

Sun Pharma has maintained a relatively stable tax burden over the years, ranging between 0.60x and 1.04x. The higher tax burden in FY21 (1.04x) suggests tax benefits or deferred tax adjustments that increased net profit relative to pre-tax earnings. However, in FY22 (0.73x) and FY24 (0.86x), the lower tax burden indicates a higher proportion of earnings paid in taxes, which could have impacted net profits. 

Lupin, on the other hand, has shown significant fluctuations in its tax burden, even turning negative in FY20 (-0.30x) and FY22 (1.11x). A negative tax burden suggests that the company recorded a net tax benefit, possibly due to tax credits or deferred tax assets. The high tax burden in FY22 (1.11x) indicates that pre-tax earnings were negative, leading to an unusual ratio. However, FY24 (0.79x) shows some stability, suggesting better tax efficiency compared to previous years. Overall, Sun Pharma has maintained a more predictable tax structure, while Lupin has faced volatility, likely due to inconsistent profitability and tax adjustments. 

1.2 Interest burden
Interest Burden measures how much of a company's operating profit remains after paying interest expenses. It is calculated as Earnings Before Tax (EBT) divided by Earnings Before Interest and Tax (EBIT). A ratio closer to 1 indicates low or no interest expenses, meaning the company retains most of its operating profit before taxes. A lower ratio suggests higher interest costs, reducing pre-tax earnings and indicating significant debt obligations. If the interest burden is near zero, it means most of the operating profit is consumed by interest payments, which can impact financial stability. A declining interest burden signals rising debt costs, while a stable or high ratio suggests manageable debt levels. 

Following is the calculation of Interest burden for Sun Pharma and Lupin: 

Sun Pharma Ltd.:
Sun Pharma has maintained a strong interest burden ratio, consistently above 0.85x, indicating efficient debt management. The ratio has improved over time, reaching 0.98x in FY23 and FY24. A higher interest burden (closer to 1) suggests that interest expenses are relatively low compared to EBIT, which is positive for profitability. This stability reflects a well-managed financial structure with controlled debt costs. 

Lupin Ltd.:
Lupin’s interest burden has been more volatile, dropping to 0.71x in FY20 and 0.72x in FY23, indicating higher interest expenses relative to earnings. A notable spike to 1.12x in FY22 was due to negative EBIT, which distorts the ratio. The recovery to 0.89x in FY24 suggests improved financial health, but the fluctuations indicate inconsistent profitability and higher financial risk compared to Sun Pharma. 

1.3 Operating profit margin
EBIT Margin (Earnings Before Interest and Taxes Margin) measures a company's operating profitability and is calculated as EBIT divided by Revenue, expressed as a percentage. A higher EBIT margin indicates strong operational efficiency, effective cost management, and higher profitability before interest and tax expenses. Conversely, a lower EBIT margin suggests higher operating costs or weaker pricing power, reducing overall profitability. A negative EBIT margin means the company is operating at a loss before accounting for interest and taxes. A stable or improving EBIT margin reflects a financially healthy business with strong core operations. 

Following is the calculation of EBIT margins for Sun Pharma and Lupin: 

For Sun Pharma Ltd., the EBIT margin has shown an overall improving trend. It increased from 18.97 per cent in March 2018 to 28.48 per cent in March 2024. The margin saw a dip in March 2021 (16.84 per cent) and March 2022 (17.12 per cent) before rebounding significantly to 27.40 per cent in March 2023 and further improving to 28.48 per cent in March 2024. This indicates enhanced operational efficiency, strong revenue growth, and possibly better cost management over the years. For Lupin Ltd., EBIT margin has been highly volatile. It was 11.58 per cent in March 2018, peaked at 18.02 per cent in March 2019, but dropped significantly in March 2022 to just 2.50 per cent, indicating financial stress, possibly due to higher costs or lower pricing power. However, the margin improved in subsequent years, reaching 19.54 per cent in March 2024, signalling a recovery in profitability. The sharp fluctuations suggest periods of inefficiency and operational challenges, but the recent improvement indicates a potential turnaround. 

The primary factor responsible for weak net profit margins in Lupin is its high interest burden, as seen in March 2022, where despite having a positive EBIT, the net profit turned negative due to financial expenses. While low EBIT margin also plays a role, the direct impact of interest costs on net profit is more severe in Lupin's case. 

2. Total asset turnover
Total Asset Turnover measures how efficiently a company uses its assets to generate revenue. A higher ratio indicates better efficiency, meaning the company generates more sales per unit of assets. A lower ratio suggests inefficient asset utilization. This varies by industry—retail and FMCG typically have high turnover, while capital-intensive industries like manufacturing have lower ratios. A higher asset turnover is generally better but should be compared with industry benchmarks. 

Following is the calculation of Total asset turnover for Sun pharma and Lupin: 

Sun Pharma's asset turnover ratio has remained relatively stable, ranging between 0.4x and 0.6x, indicating that the company has a lower efficiency in utilizing its assets to generate revenue. This is expected for a capital-intensive industry like pharmaceuticals. 

Lupin Ltd., on the other hand, has shown a higher and improving asset turnover ratio, increasing from 0.6x to 0.9x in recent years. This suggests that Lupin is generating more revenue per unit of assets compared to Sun Pharma. The improvement in asset turnover could indicate better operational efficiency or a leaner asset base supporting revenue growth. However, while a higher asset turnover is beneficial, other financial metrics like profitability and cost structure must also be considered for a complete analysis. 

3. Equity Multiplier
The equity multiplier is a financial ratio that measures a company's reliance on debt versus equity to finance its assets. It is calculated by dividing total assets by total equity. A higher equity multiplier indicates greater financial leverage, meaning the company relies more on debt, which can enhance returns but also increases financial risk. Conversely, a lower equity multiplier suggests the company depends more on equity financing, reducing risk but potentially limiting return potential. To assess whether a company's leverage is appropriate, it should be compared with industry peers. 

Following is the calculation of Total asset turnover for Sun Pharma and Lupin: 

The Equity Multiplier for Sun Pharma has gradually declined from 1.67x to 1.39x over time, indicating a reduction in financial leverage. This suggests that the company has been decreasing its reliance on debt and increasing equity financing. A lower equity multiplier reflects a more conservative capital structure, which helps reduce financial risk but may also limit the potential for amplified returns through leverage. 

In contrast, Lupin's Equity Multiplier has remained higher, fluctuating between 1.74x and 2.00x, indicating a greater reliance on debt financing. While higher leverage can enhance returns when earnings grow, it also increases financial risk, especially during periods of earnings pressure. This suggests that Lupin is maintaining a more aggressive capital structure compared to Sun Pharma. 

These ratios are often manipulated by companies to present a stronger ROE. Let’s explore how this is done. 

Tax Burden (Net Income / EBT)

• Structuring income as capital gains (lower tax rate) instead of regular income.
• Effect on ROE: A lower tax burden (due to tax planning) artificially boosts ROE, but it's not a true reflection of operational efficiency. 
   

Interest Burden (EBT / EBIT)

• Refinancing debt at lower interest rates to reduce interest expenses artificially.
• Capitalizing interest (recording it as an asset rather than an expense) to make EBT appear stronger.
• Using financial engineering, such as issuing convertible bonds, to defer interest expenses.
• Effect on ROE: Lower interest expenses increase ROE, but aggressive tactics can be misleading if real debt obligations remain high. 
   

Operating Margin (EBIT / Revenue)

• Aggressive revenue recognition – Booking sales before actual delivery (e.g., Enron, Sunbeam).
• Understating expenses – Capitalizing expenses (e.g., WorldCom capitalizing operating costs as assets).
• Effect on ROE: Artificially improving EBIT increases ROE, but it's unsustainable and risky if real cash flow doesn't support it. 
   

Asset Turnover (Revenue / Assets) Equity Multiplier (Assets / Equity)

• Taking on excessive debt – More debt reduces equity, increasing ROE artificially but making the company riskier.
• Stock buybacks – Reducing equity (without improving performance) to inflate ROE (e.g., IBM's buybacks in the 2010s).
• Off-balance-sheet liabilities – Hiding debt in special purpose vehicles (SPVs), like Enron did, to make leverage look lower.
• Effect on ROE: A higher equity multiplier increases ROE, but excessive leverage increases financial risk. 
   

Why DuPont Analysis is a Powerful Tool for Evaluating a Company
When analysing a company's financial performance, relying on a single ratio like Return on Equity (ROE) can be misleading. The DuPont Analysis provides a deeper breakdown, helping investors understand what truly drives ROE and whether it is sustainable.

• Uncovers True ROE Drivers: A high ROE might seem attractive, but is it driven by profitability, efficiency, or excessive leverage? DuPont Analysis helps dissect the exact contributors.
• Detects Financial Manipulation: Companies can artificially inflate ROE through high leverage or tax optimisation, making performance appear better than it actually is. DuPont exposes such tactics.
• Enhances Peer Comparisons: Two companies may report similar ROEs, but one might have stronger margins, while the other relies on higher debt—a crucial insight for investors.
• Supports Better Decision-Making: By breaking down ROE into actionable components, companies and investors can pinpoint areas for improvement, whether in cost control, asset utilisation, or capital structure. 
   

Conclusion
DuPont Analysis goes beyond just one ratio; it breaks down ROE into multiple factors, giving investors and analysts a holistic view of a company’s financial strength. By examining each component, we can better assess a company's true performance and sustainability, rather than just relying on a single number.