Forecasting operating profitability with DuPont analysis

Abstract

Purpose – The purpose of this study is to re-examine the relation between changes in profit margin (ΔPM) and changes in return on net operating assets (ΔRNOA) by partitioning on the direction of the change in PM. DuPont analysis provides a means of disaggregating a firm’s return on net operating assets (RNOA) into asset turnover (ATO) and profit margin (PM) components to gain insights into the underlying drivers of operating profitability. Prior research finds that changes in ATO are informative about one-year-ahead changes in RNOA, while changes in PM are not. Design/methodology/approach – Consistent with prior research, regression analysis is used to develop a predictive model for one-year-ahead changes in RNOA. Results based on in-sample parameter estimates are used to examine the out-of-sample forecasting accuracy of alternative model specifications. Findings – The results are consistent with significant forecast improvement resulting from considering the impact on future RNOA of the direction of the ΔPM. Originality/value – The study contributes to the literature on the determinants of profitability ratios by providing further guidance on how financial statement information can be utilized to improve forecasts of firm performance.