Question

Critically analyze and discuss DuPont Method to measure ROE.

Answer 1

The DuPont analysis is a way of decomposing and examining the financial ratio return on equity (ROE).  ROE looks at how much a company earned in the previous period compared with the total amount of owners’ equity invested in the business.In DUPONT ROE analysis we identify some of the underlying drivers of the ratio.

A DuPont analysis begins with the company’s return on equity (ROE). The formula for that is

ROE = Net Income/Equity,

Decomposing Return on Equity

ROE under DUPONT analysis composed of:

It turns out that we can decompose or break ROE down into component parts through a mathematical identity. ROE = Net Income / Equity = (Net Income/ Sales) * (Sales / Assets) * (Assets / Equity).

ROE = profit margin*total asset turnover*equity multiplier

This works because it’s an identity: Net Income / Equity = (Net Income / Sales) * (Sales / Assets) * (Assets / Equity).

Profit margin, as the name implies, tells you how profitably you are running the business. Are you barely covering your costs or do you have a pretty good cushion.

Asset Turnover measures the amount of sales a company has relative to the assets it has to own and maintain in order to generate those revenues. The amount of turnover can tell us a fair bit about how the business operates.

Financial Leverage is an indication of how much Debt the company uses to finance the generation of revenues.

thus we can say that ROE under DUPONT anlsysis is a result of profitmargin, asset turnover and equity multiplier