7. DuPont equation Aa Aa Corporate decision makers and analysts often use a part

Question

7. DuPont equation Aa Aa 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 the 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 x Total Assets Turnover X Total Assets Sales 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: Company A Company B Company C ROE = Profit Margin x Total Assets Turnover x Equity Multiplier 12.0% 15.5% 21.5% 57.3% 58.2% 58.0% 9.8 10.2 10.3 2.14 2.61 3.60 Referring to these data, which of the following conclusions will be true about the companies' ROEs? O The main driver of company C's superior ROE, as compared to that of company A's and company B'S ROE, is its operational efficiency O The main driver of company A's inferior ROE, as compared to that of company B's and company C's ROE, is its use of higher debt financing O The main driver of company C's superior ROE, as compared to that of company A's and company B's ROE, is its greater use of debt financing

Explanation / Answer

Dupont analysis is done to understand the variables that drive a company's ROE The Analysis is done by considering the below ratios or variables to calculate the ROE ROE = Profit Margin*Total Assets Turnover*Equity Mutiplier Net profit/Sales * Sales/Total Assets*Total Assets/Total Common Equity The Main Driver of company C's superior ROE as compared to that of Company A's and company B's ROE, is its greater use of debt financing As can be seen from the data, Company B and C as almost similar profit margin and total assets turnover but the only distingushing factor is the equity multiplier of company C which represents higher use of debt by company C. Also, company A's use of debt is less than that of company B and C The correct answer is option C

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