Question

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 = Profit Margin X Total Assets Turnover X L X Total Assets Total Common Equity Sales Total Assets

A
B
C

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:

	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 C’s superior ROE, as compared to that of company A’s and company B’s ROE, is its greater use of debt financing.

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.

The main driver of company A’s inferior ROE, as compared to that of company C’s ROE, is its higher total asset turnover ratio.

Answer 1

A	Equity Multiplier
B	Net Income
C	Sales

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The correct answer is: 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.

Company C has significantly higher equity multiplier in comparison to that of A & B. And that's the reason behind it's superior ROE. All the three companies have other ratios very close by.