102 Part 2 Fundamental Concepts in Financial Management
stockholders. Therefore, the return on assets must be adjusted upward to obtain
the return on equity.- That brings us to the third term, the equity multiplier, which is the adjust-
ment factor. Allied’s assets are 2.13 times its equity, so we must multiply
the 5.9% return on assets by the 2.13# equity multiplier to arrive at its ROE
of 12.5%.
Note that ROE as calculated using the DuPont equation is identical to Allied’s
ROE, 12.5%, which we calculated earlier. What’s the point of going through all of
the steps required to implement the DuPont equation to! nd ROE? The answer is
that the DuPont equation helps us see why Allied’s ROE is only 12.5% versus 15.0%
for the industry. First, its pro! t margin is below average, which indicates that its
costs are not being controlled as well as they should be and that it cannot charge
premium prices. In addition, because it uses more debt than most companies, its
high interest charges also reduce the net pro! t margin. Second, its total assets
turnover is below the industry average, which indicates that it has more assets
than it needs. Finally, because its equity multiplier is relatively high, its heavy use
of debt offsets to some extent its low pro! t margin and turnover. However, the
high debt ratio exposes Allied to above-average bankruptcy risk; so it might want
to cut back on its! nancial leverage. But if it reduced its debt to the same level as
the average! rm in its industry, its ROE would decline signi! cantly, to 3.92% #
1.5 # 1.67! 9.8%.^16
Allied’s management can use the DuPont equation to help identify ways to
improve its performance. Focusing on the pro! t margin, its marketing people can
study the effects of raising sales prices or of introducing new products with higher
margins. Its cost accountants can study various expense items and, working with
engineers, purchasing agents, and other operating personnel, seek ways to cut
costs. The credit manager can investigate ways to speed up collections, which
would reduce accounts receivable and therefore improve the quality of the total
assets turnover ratio. And the! nancial staff can analyze the effects of alternative
debt policies, showing how changes in leverage would affect both the expected
ROE and the risk of bankruptcy.
As a result of this analysis, Ellen Jackson, Allied’s chief executive of! cer (CEO),
undertook a series of moves that are expected to cut operating costs by more than
20%. Jackson and Allied’s other executives have a strong incentive to improve the
! rm’s! nancial performance—their compensation depends on how well the com-
pany operates. If Allied meets or exceeds its growth and pro! t targets, Jackson and
the other executives—and the stockholders—will do well. Otherwise, someone
like Warren Buffett or Carl Icahn, whom we discussed at the beginning of the
chapter, may come calling.
SELF^ TEST Write the equation for the basic DuPont equation.
What is the equity multiplier, and why is it used?
How can management use the DuPont equation to analyze ways of improving
the! rm’s performance?(^16) The ROE reduction would actually be somewhat less because if debt were lowered, interest payments would
also decline, which would raise the pro! t margin. Allied’s analysts determined that the net e" ect of a reduction in
debt would still be a signi! cant reduction in ROE.