Corporate decision makers and analysts often use a particular technique, called
ID: 2615275 • Letter: C
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. According to the equation, which of the following factors directly affect a company's ROE? Check all that apply Price per Share Earnings per Share Sales / Total Assets Net Income/ Sales 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 12.0% 15.5% 21.5% Profit Margin x Total Assets Turnover x Equity Multiplier Company A Company B Company C 57.3% 58.2% 58.0% 9.8 10.2 10.3 2.14 2.61 3.60 Referring to these data, which of the following conclusions will be true about the companies' ROEs? O The main driver of company A's inferior ROE, as compared to that of company B's and company C's ROE, is its use of higher debt financing O 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 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 financingExplanation / Answer
DuPont relation breaks down ROE into more granular ratios to help indicate drivers of the ROE of a company.
ROE = Net profit Margin * Total Asset Turnover Ratio * Equity Multiplier
ROE = (Net Income/Sales) * (Sales/Total Assets) * (Total Assets/Equity)
Based on the ratio above, first question has correct answer as Option 2 and Option 3.
Second Question - Answer is Option C
First statement is incorrect. Lower Asset to Equity ratio mean lower proportion of debt in capital structure. For Company A, since equity multiplier is low, it implies lower debt financing
Second statement is incorrect. Asset turonver ratio is lower for company A.
Third statement is correct. Company C has the highest equity multiplier. Equity multiplier = Total Assets/Equity. Higher Equity multiplier means less equity has been used to finance assets. Hence, more debt financing in company's capital structure.