Question

Describe how to use DuPont identity in financial analysis.

Answer 1

DU Pont model use to determine return on equity for shareholder. according to this model, return on equity depends on three factors,

Equity Multiplier

Equity multiplier mean what proportion of total assets finance with debt and what proportion of assets financed by debt. if company use more debt than equity multiplier would be high and so return on equity must be high.

Assets turnover

Assets turnover ratio denote how effectively company able to use its total assets to convert them in to sale. if assets turnover is high, it means company use its assets more efficiently so return on equity must be high.

Profit margin

Profit margin states proportion of total sales as profit. this ratio states the effective of management in managing cost in production. if cost of production is low then profit margin must be high. if profit margin would be high then return on equity must be high.

Return on equity is calculated below using Du Pont Formula:

Return on equity = Equity Multiplier × Assets turnover × Profit margin