Fundamentals of Financial Management (Concise 6th Edition)

Chapter 4 Analysis of Financial Statements 101

4-8 THE DUPONT EQUATION

We have discussed many ratios, so it would be useful to see how they work
together to determine the ROE. For this, we use the DuPont equation, a formula
developed by the chemical giant’s! nancial staff in the 1920s. It is shown here for
Allied and the food processing industry.

ROE! Pro! t margin " Total assets turnover " Equity multiplier

! Net (^) Salesincome " Total Salesassets " ___Total Total common assets (^) equity 4-1
! $117.5__
$3,000
" $3,000__
$2,000
" $2,000__
$940
! 3.92% " 1.5 times " 2.13 times! 12.5%
Industry! 5.0% " 1.8 times " 1.67 times! 15.0%

• The! rst term, the pro! t margin, tells us how much the! rm earns on its sales.
  This ratio depends primarily on costs and sales prices—if a! rm can command
  a premium price and hold down its costs, its pro! t margin will be high, which
  will help its ROE.


• The second term is the total assets turnover. It is a “multiplier” that tells us how
  many times the pro! t margin is earned each year—Allied earned 3.92% on each
  dollar of sales, and its assets were turned over 1.5 times each year; so its return
  on assets was 3.92% # 1.5! 5.9%. Note, though, that this entire 5.9% belongs
  to the common stockholders—the bondholders earned a return in the form
  of interest, and that interest was deducted before we calculated net income
  to stockholders. Therefore, the whole 5.9% return on assets belongs to the

DuPont Equation

A formula that shows that

the rate of return on equity

can be found as the

product of net profit

margin, total assets

turnover, and the equity

multiplier. It shows the

relationships among asset

management, debt

management, and

profitability ratios.

DuPont Equation

A formula that shows that

the rate of return on equity

can be found as the

product of net profit

margin, total assets

turnover, and the equity

multiplier. It shows the

relationships among asset

management, debt

management, and

profitability ratios.

16

14

12

10

ROE

(%)

2004 2005 2006 2007 2008

Industry

Allied

Rate of Return on Common Equity, 2004–2008

F I G U R E 4' 1

SEL

F^ TEST How is a trend analysis done?

What important information does a trend analysis provide?