Question

10. The DuPont equation Aa Aa E Corporate decision makers and analysts often use a technique called DuPont analysis to understand and assess the factors that drive a company's financial performance, as measured by its return on equity (ROE). Depending on the version used, the DuPont equation will deconstruct the firm's 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 firm's ROE performance. Complete the following sentences by entering the appropriate words or phrases. In the extended DuPont equation, a firm's 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 firm's efficiency and profitability metrics are multiplied and summarized in a single measure, the . In this analysis, a company's financial performance is expected to result from both management's financing decisions and its effectiveness and efficiency in generating profits using the firm's asset base. Most investors and analysts in the financial community observe a firm's ROE closely. The ROE can be calculated by dividing the firm's 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: The following dollar values are expressed in millions of U.S. dollars.) Total Assets Common Equity Net Income Firm Sales NPM ТАТ EM ROE 8.91 $35,050 $17,078 $37,402 B C $3,933 $6,510 $5,195 $67,713 $8,170 $24,363 $7,498 $1,113 $3,907 11.07% 13.62% 0.48 0.65 7.20 Referring to this data, which of the following conclusions is true about the companies' ROES? O O Compared to companies A and C, company B uses more financial leverage and exhibits the highest debt ratio. 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 A's exceptional ROE performance appears to result from its superior efficiency in using its asset base and its heavily leveraged capital structure. Firm A's equity multiplier indicates that it has the lowest debt ratio of the three firms.

Answer 1

In the extended DuPont equation, a firm’s ROE reflects (1) its use of debt financing, or leverage, as reflected by its Equity Multiplier (EM), (2) the efficiency with which it uses its assets, as measured by the Total Asset Turnover (TAT), and (3) its ability to generate sales and manage its production costs and operating expenses, as summarized by its Net Profit Margin (NPM).

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 firm’s efficiency and profitability metrics are multiplied and summarized in a single measure, the ROA. In this analysis, a company’s financial performance is expected to result from both management’s financing decisions and its effectiveness and efficiency in generating profits using the firm’s asset base.

• Equity Multiplier(EM)
  Average Total Assets Average Total Equity
  

This ratio indicates how much of a company’s assets are financed by the shareholder’s equity. A low value of EM is considered good as it means that a low amount of assets are financed by or depended on the equity financing.

• Total Asset Turnover (TAT) =
  Net Sales Total Assets
  

This ratio measures the ability of the assets of a company to generate sales. A higher ratio is considered better.

• Net Profit Margin (NPM) =
  Net Profit Revenue
  

This ratio measures the value of net profit per revenue generated by a company. The higher the NPM ratio, the better it is.

• Return on Assets (ROA):

ROA =

Net Income Total Assets

This ratio measures the efficiency with which a company can generate net income per total assets of the company. The higher the value of the ratio, the better it is.