10. The DuPont equation

Corporate decision makers and analysts often use a technique called DuPont analysis to understand and assess the factors that drive a companys financial performance, as measured by its return on equity (ROE). Depending on the version used, the DuPont equation will deconstruct the firms 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 firms ROE performance. Complete the following sentences by entering the appropriate words or phrases.

In the extended DuPont equation, a firms ROE reflects (1) its use of debt financing, or leverage, as reflected by its , (2) the efficiency with which it uses its assets, as measured by the , and (3) its ability to generate sales and manage its production costs and operating expenses, as summarized by its .

In contrast, sometimes it is useful to focus just on asset profitability and financial leverage. In this case, you would use the traditional version of the equation, in which the firms efficiency and profitability metrics are multiplied and summarized in a single measure, the . In this analysis, a companys financial performance is expected to result from both managements financing decisions and its effectiveness and efficiency in generating profits using the firms asset base.

Most investors and analysts in the financial community observe a firms ROE closely. The ROE can be calculated by dividing the firms 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 fiscal year 2018 data for firms operating in the agricultural 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: Round your answers to two decimal places. The following dollar values are expressed in millions of U.S. dollars.)

Firm	TotalAssets	CommonEquity	Sales	NetIncome	NPM	TAT	EM	ROE
A	$35,050	$3,933	$67,713	$7,498	11.07%		8.9118
B	$17078	$6,510	$8,170	$1,113	13.62%	0.48
C	$37,402	$5,195	$24,363	$3,907		0.65	7.20

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

Compared to firms B and C, company A does the best job of containing its costs and managing its tax obligations.

Compared to firms B and C, company As exceptional ROE performance appears to result from its superior efficiency in using its asset base and its heavily leveraged capital structure.

Compared to companies A and C, company B uses more financial leverage and exhibits the highest debt ratio.

Firm As equity multiplier indicates that it has the lowest debt ratio of the three firms.