Question

5. If we know that a firm has a net profit margin of 4.5%, total asset turnover of 0.72, and a financial leverage multiplier of 1.43, what is its ROE? 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

DuPont equation is used to calculate return on equity (ROE) in following manner-

ROE = Profit margin * Total assets turnover * Financial leverage multiplier

Where,

Profit margin = 4.5%

Total assets turnover = 0.72

Financial leverage multiplier = 1.43

Therefore,

ROE = 4.5% * 0.72 * 1.43 = 0.046332 or 4.6332%

Return on equity (ROE) is 4.6332%.

This formula can be expended in following way -

ROE = (Net Income /Sales) * (Sales/Total asset)* (Total assets /Equity)

We can see in DuPont equation that return of equity (ROE) has three determinants profitability (Net Income /Sales), efficiency (Sales/Total asset) and financial leverage (Total assets /Equity). The advantage to using the DuPont system to calculate ROE is that a company can know that what factors are pushing its ROE i.e. its ROE increasing by increasing its financial leverage, increasing its profit margins or assets turnover. The direct calculation of earnings available for common stockholders divided by common stock equity gives ROE without its main determinants.