9. 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 the better or worse, and identify particular company strengths and weaknesses.

The DuPont Equation

Question #1 A DuPont analysis is conducted using the DuPont equation, which helps to identify and analyze three important factors that drive a companys ROE. According to the equation, which of the following factors directly affect a companys ROE?

Check all that apply.

A. Market-to-book-value ratio B. Efficiency in use of total assets C. Operational efficiency

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

Question #2 Referring to these data, which of the following conclusions will be true about the companies ROEs?

A. The main driver of company Cs superior ROE, as compared to that of company As and company Bs ROE, is its efficient use of assets. B. The main driver of company As inferior ROE, as compared to that of company Cs ROE, is its higher total asset turnover ratio. C. The main driver of company Cs superior ROE, as compared to that of company As and company Bs ROE, is its greater use of debt financing.