Question

14. The DuPont equation

Corporate decision makers and analysts often use a technique called DuPont analysis to understand and assess the factors that drive a company’s financial performance, as measured by its return on equity (ROE). Depending on the version used, the DuPont equation will deconstruct the firm’s ROE, its best measure of financial performance, into two or three important factors, or drivers.

DuPont analysis can be conducted using either the traditional DuPont equation or the extended DuPont equation. The traditional equation is constructed using two drivers, whereas the extended DuPont equation uses three variables to examine a firm’s ROE performance.

Complete the following sentences by entering the appropriate words or phrases.

pt A) In the extended DuPont equation, a firm’s ROE reflects (1) its use of debt financing, or leverage, as reflected by its (total asset turnover ratio OR return on assets ratio OR equity multiplier ratio) , (2) the efficiency with which it uses its assets, as measured by the (return on asset ratio OR total asset turnover ratio OR return on equity), and (3) its ability to generate sales and manage its production costs and operating expenses, as summarized by its (net profit margin OR gross profit margin OR equity multiplier ratio).

pt B) In contrast, in the traditional version of the equation, the firm’s efficiency and profitability metrics are multiplied and summarized in a single measure, the (return on assets ratio OR total asset turnover ratio OR net profit margin). In this analysis, a company’s financial performance is expected to result from both management’s financing decisions and its effectiveness and efficiency in generating profits using the firm’s asset base.

Most investors and analysts in the financial community observe a firm’s ROE closely. The ROE can be calculated by dividing the firm’s net income by the shareholders’ equity, or it can be reduced into the key factors that drive the ROE. Investors and analysts like to focus on these drivers to develop a more holistic image of what is changing within a company.

An analyst collected the following data for firms operating in the transportation sector. Use the data to compute the net profit margin (NPM), total asset turnover (TAT), and equity multiplier (EM) values required for a DuPont analysis.

Note: The following dollar values are expressed in millions of U.S. dollars.).

Firm	Total Assets	Common Equity	Sales	Net Income	NPM	TAT	EM	ROE
A	$28,141	$8,700	$10,636	$1,563	14.70%	0.30x/0.38x/0.35x (choose one)	3.23	18.04%/7.22%4.51% (choose one)
B	$5,641	$2,431	$18,158	$180	0.99%	3.22x	2.09/2.67/2.32 (choose one)	7.40%/6.77%/9.99% (choose one)
C	$28,199	$10,669	$9,516	$1,496	13.36%/15.72%/16.51% (choose one)	0.34x	2.64	20.46%/14.11%/9.24% (choose one)

pt C) Referring to this data, which of the following conclusions is true about the companies’ ROEs?

a) Company B’s ROE performance results from its terrible profitability and cost-containment performance, and despite its superior asset-management productivity performance.

b) Firm A exhibits the lowest debt ratio among the three firms.

c) Although the three firms exhibit relatively similar efficiencies in managing its asset bases, firm C is marginally better in doing so.

d) Compared to firms A and B, firm C exhibits the worst job of managing its operating efficiency by reducing its costs and tax burden.

Answer 1

Firm	Total Assets	Common Equity	Sales	Net Income	NPM	TAT	EM	ROE
A	$28,141	$8,700	$10,636	$1,563	14.70%	0.38x	3.23	18.04%
B	$5,641	$2,431	$18,158	$180	0.99%	3.22x	2.32	7.40%
C	$28,199	$10,669	$9,516	$1,496	15.72%	0.34x	2.64	14.11%
a) Company B’s ROE performance results from its terrible profitability and cost-containment performance, and despite its superior asset-management productivity performance.