Many times ratios computed for a firm give a conflicting picture of performance.

Question

Many times ratios computed for a firm give a conflicting picture of performance. The DuPont Identity provides a way to breakdown ROE and investigate what areas of the firm need improvement.

The DuPont Identity indicates that a firm’s return on equity depends on its operating efficiency (profit margin), asset use efficiency (total asset turnover), and financial leverage (equity multiplier).

                                    Equity multiplier (EM) = TA/TE = 1 + debt/equity ratio

Based on the Du Pont identity, the following factors affect the growth rate:

- Profit margin

- Total asset turnover –

- Financial policy

- Dividend policy

Please explain how they affect the growth rate of a company.

Explanation / Answer

Profit margin: Higher profit margin means higher pricing power means higher growth

Total asset turnover: Higher asset turnover means higher/more efficient utilisation of assets means higher growth

Financial Policy: Higher Debt/Equity means higher growth

Dividend Policy: Higher dividends means lesser reinvestments mens lesser growth

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