Question

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	×
	=	/ Sales	×	/ 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 C’s superior ROE, as compared with that of Company A’s and Company B’s ROE, is its operational efficiency.

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.

Answer 1

The equation is

ROE = Profit Margin * Total Assets Turnover * Equity Multiplier

ROE = Net Income/Sales * Sales/Total Assets * Total Assets/Total Common Equity

The correct statements are:

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.

Equity multiplier = Total Assets/Total Common Equity

Since Equity multiplier is higher, equity is lower for Company C which reflects higher debt financing

Company A uses lower debt financing

Profit Margins are almost same