DuPont Analysis and the Decomposition of ROE
An integrated financial ratio analysis means using all the ratios at your disposal to create a more complete picture of a company's finances. Ratios from each group, including activity, liquidity, solvency, and profitability, should be viewed in combination as ratios from one group may answer questions raised in another group of ratios.
If James Corp had net income of USD 10M, average assets of USD 100M and average equity of USD 50M, what would be its ROE?
That's correct.
The calculation is 10/100 x 100/50 = 0.2, or 20%.
Not correct.
That would be ROA, or return on assets. Don't forget the leverage piece.
Not correct.
That would be average assets/average equity. You're just missing the first piece.
The management of James Corp is interested in expanding by adding new fixed assets, but it is concerned about how the ratios will look after it does so.
If James Corp were to add USD 50M in assets that generated USD 5M of new income and financed it with debt, what would happen to the ROE?
Correct.
James Corp's management would like to know more. It finds that DuPont analysis will allow the ROA to be broken down into two parts, net profit margin and asset turnover. The new formula for ROE would then be
$$\displaystyle \text{ROE}= \frac{\text{net income}}{\text{revenue}} \times \frac{\text{revenue}}{\text{average total assets}} \times\frac{\text{average total assets}}{\text{average shareholders' equity}}$$.
Now, management can see that generating more revenue and income for each dollar of assets will also raise its ROE.
DuPont analysis allows you to break net income/revenue into three pieces: tax burden, interest burden, and operating margin. That creates a five-way breakdown for ROE that would look like this:
$$\displaystyle ROE=\frac{\text{net income}}{\text{EBT}} \times \frac{\text{EBT}}{\text{EBIT}} \times \frac{\text{EBIT}}{\text{revenue}} $$
> $$\displaystyle \times\frac{\text{revenue}}{\text{avg. total assets}} \times\frac{\text{avg. total assets}}{\text{avg. shareholders equity}} $$
Remember, EBT is earnings before taxes and EBIT is earnings before interest and taxes.
What do you think is an advantage of breaking down ROE into five components as opposed to three?
Correct .
It breaks the net profit margin into three subcomponents: tax burden, interest burden and EBIT margin.
Not correct.
It breaks the net profit margin, not asset turnover, into three subcomponents.
To sum up:
[[summary]]
Incorrect.
Think about the effect of increase in assets, given how they are financed.
Recall that ROE measures the returns a firm earns on its equity capital. The formula is
$$\displaystyle \text{ROE}=\frac{\text{net income}}{\text{average shareholders' equity}}$$
To understand what drives ROE, break it down into its components, ROA and Leverage. Since
$$\displaystyle \text{ROA} =\frac{\text{net income}}{\text{average total assets}}$$
and
$$\displaystyle \text{Leverage} = \frac{\text{average total assets}}{\text{average shareholders' equity}}$$,
that means
$$\displaystyle \text{ROE}= \text{ROA} \times \text{Leverage}$$
$$\displaystyle = \frac{\text{net income}}{\text{average total assets}} \times \frac{\text{average total assets}}{\text{average shareholders' equity}}$$.
The calculation would be 15/50 = 0.3 or 30% after the transaction, which would be an increase in ROE.
Net income increases by 5 to 15, and equity remains unchanged because the addition to assets is balanced by an equal addition of debt.
Using DuPont analysis, James Corp's management has quite a bag of tools to use to raise its ROE. That will be good for the company's stock price and should keep the equity holders happy.
2
0.2 or 20%
0.10 or 10%
It would be lower after the transaction
It would be higher after the transaction
It breaks the net profit margin into three components, allowing you to isolate impacts
It breaks the asset turnover into three components, allowing you to isolate impacts
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