Question

A firm has a net profit margin of 4.5%, a total asset turnover of 0.72, and a financial leverage multiplier of 1.43.

1. Calculate the firm's ROA and ROE.

2. What is the advantage to using the DuPont system to calculate ROE over the direct calculation of earnings available for common stockholders divided by common stock equity?

Answer 1

Q1:

ROA= net income/assets = net profit margin*asset turnover = 4.5*.72 =3.24%

ROE=ROA*leverage multiplier= 3.24*1.43=4.633%

Q2:

Dupont equation defines ROE=net income/equity into product of 3 components;

ie ROE=net profit margin*asset turnover*financial leverage

Through this split up of the equation, we will be able to understand how much of the Return on Equity comes from increase in profit margin, how much of it comes from increase in asset turnover and how much from increasing leverage or debt.

For a firm, they can increase the ROE through these parameters and generally if a firm increase ROE only through raising more debts, it is not considered as a good indication of the performance of the firm, where as it is positive for a firm to raise the ROE through Asset turnover or profit margin. Through Dupont analysis, we can identify such variations in ROE>