Question

The DuPont equation

Corporate decision makers and analysts often use a particular technique, called a DuPont analysis, to better understand the factors that drive a company’s financial performance, as reflected by its return on equity (ROE). By using the DuPont equation, which disaggregates the ROE into three components, analysts can see why a company’s ROE may have changed for better or worse and identify particular company strengths and weaknesses.

The DuPont Equation

A DuPont analysis is conducted using the DuPont equation, which helps to identify and analyze three important factors that drive a company’s ROE. Complete the following equations, which are needed to conduct a DuPont analysis:

ROE	=	Profit Margin	×	Total Assets Turnover	×	Equity multiplier, retained earinings,return on assets
	=	Net, income ,Net sale,gross profit / Sales	×	sale,ebit,net income / Total Assets	×	Total Assets / Total Common Equity

Most investors and analysts in the financial community pay particular attention to a company’s ROE. The ROE can be calculated simply by dividing a firm’s net income by the firm’s shareholder’s equity, and it can be subdivided into the key factors that drive the ROE. Investors and analysts focus on these drivers to develop a clearer picture of what is happening within a company. An analyst gathered the following data and calculated the various terms of the DuPont equation for three companies:

	ROE	=	Profit Margin	x	Total Assets Turnover	x	Equity Multiplier
Company A	12.0%		57.3%		9.8		2.14
Company B	15.5%		58.2%		10.2		2.61
Company C	21.5%		58.0%		10.3		3.60

Referring to these data, which of the following conclusions will be true about the companies’ ROEs?

The main driver of Company A’s inferior ROE, as compared with that of Company C’s ROE, is its higher total asset turnover ratio.

The main driver of Company C’s superior ROE, as compared with that of Company A’s and Company B’s ROE, is its greater use of debt financing.

The main driver of Company C’s superior ROE, as compared with that of Company A’s and Company B’s ROE, is its operational efficiency.

Answer 1

Among the given conclusions,

2nd conclusion is TRUE, as the main driver of company C's superior ROE is its greater use of debt financing which is represented by equity multiplier. company C's equity multiplier of 3.6 is much higher than that of company A's 2.14.

Lets see why the remaining options are wrong.

1st conclusion is WRONG, as total asset turnover ratio, of company A is lower than that of company C

3rd conclusion is Wrong, Beacuse oprerational efficiency is represented by profit margin and it is not the main driver of company C's superior ROE. Main driver is greater use of debt financing which is represented by equity multiplier.