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. According to the equation, which of the following factors directly affect a company’s ROE? Check all that apply.

Equity multiplier

Share price

Total assets turnover ratio

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 B’s and Company C’s ROE, is its use of higher 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 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 efficient use of assets.

Answer 1

Option B is correct.

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.

If we have a close look on porfit margins they are same with +/- 1% which are almost same.

When the equity multiplier or leverage mutiplier is more we say that company is working the best. Financial leverage is the Debt/Equity which states that if debt is more then the company work fine but the debt financing should not exceed the limits.If it does the company goes bankrupt.

So here firm C is having more leverage hence option B is correct answers with high debt financing.