6. The DuPont equation Aa Aa Corporate decision makers and analysts often use a
ID: 2821139 • Letter: 6
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6. The 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 Net Profit Margin x Total Assets Turnover x Total Assets Sales Total Assets Stockholders' 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 12.0% 15.5% 21.5% Net Profit Margin x Total Assets Turnover x Equity Multiplier 9.8 10.2 10.3 57.3% 58.2% 58.0% 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 greater use of 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 efficient use of assets 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 financingExplanation / Answer
1) Net profit margin = Net Income / Sales
Total assets turnover = Sales / Total assets
Equity multiplier = Total assets / Stockholders' Equity
ROE = Net profit margin x Total assets turnover x Equity Multiplier
2) Among the given options, first option is true.
The main difference among the three companies can be observed in Equity multiplier. Equity multiplier is computed as -
EM = Total assets / Stockholders' Equity
This ratio will be higher for the company that uses less equity, and in turn higher debt, which will make the denominator smaller in comparison to the numerator. Thus, making the ratio higher for a company with higher debt.
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