Question

Another way of calculating a firm's ROE is by employing the DuPont Identity, commonly referred to as the DuPont Equation. How is the DuPont Equation different from the ratio presented above? Are there similarities between the two methods of calculating ROE? What does the DuPont Equation tell you that the simple equation does not?

Answer 1

Answer :- Simple equation for Return on equity (ROE) is as follows :-

Return on equity (ROE) = Net income / Average shareholder equity.

Using DuPont identity, Return on equity (ROE) is calculated as profit margin multiplied by asset turnover multiplied by financial leverage.

ROE (Return on equity) = Profit margin * Asset turnover * Financial leverage.

  Or

ROE (Return on equity) = (Net income / Sales) * (Sales / Total assets) * (Total assets / Average shareholder equity).

DuPont equation was developed and applied by Du-Pont Company of the United States, in its annual report. It provides knowledge of usage of ratio and there relation to management for help and control. DuPont model compare actual ratio with standard ratio for checking performance of business. DuPont analysis depends mainly upon two factors, profit and investment. These two factors collectively determine the profitability of the firm. In other words, these two factors when combined together determine the earning power of the firm.

Moreover, the profit margin is determined by the relationship between the selling price, cost structure and the expenses. Each of these elements has an effect on the profit margin of the firm. Inter-firm comparison techniques are used for testing of efficiency. For this purpose, investment turnover ratio, asset turnover ratio, return on investment and important profitability ratios are used. It is important tool for financial analysis and many concerns are using it. Profit margin and investment turnover both are jointly affected to return on investment. These ratios are affected by so many factors and ultimately which affects the profitability of the concern.