8. The DuPont equation

Corporate decision makers and analysts often use a particular technique, called a DuPont analysis, to better understand the factors that drive a companys 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 companys 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 companys 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 companys ROE. The ROE can be calculated simply by dividing a firms net income by the firms shareholders 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 Cs superior ROE, as compared with that of Company As and Company Bs ROE, is its greater use of debt financing.

The main driver of Company As inferior ROE, as compared with that of Company Bs and Company Cs ROE, is its use of higher debt financing.

The main driver of Company Cs superior ROE, as compared with that of Company As and Company Bs ROE, is its operational efficiency.