Corporate decision makers and analysts often use a particular technique, called the DuPont analysis, to better understand the factors that drive the company’s performance, as reflected in its return on equity (ROE). By using the DuPont equation, which disaggregates a company’s ROE into three components, analysts can see why the company’s ROE may have changed for the better or worse, and identify the company’s weaknesses and strengths. According to the DuPont equation, which of the following factors affect a company’s ROE directly? Check all that apply.
(a) Efficiency in use of total assets
(b) Market-to-book-value ratio
(c) Financial leverage
Most investors and analysts in the financial community closely observe a company’s ROE. The ROE can be calculated simply by dividing net income by the shareholder’s equity, and it can be subdivided into the key factors that drive the ROE. Investors and analysts focus on these drivers to develop a clearer picture of what is happening in a company. An analyst gathered the following data and calculated the various terms of the DuPont equation for three companies:
ROE = Profit Margin x Total Assets Turnover x Equity Multiplier
Company A 12.0% 57.3% 9.8 2.14
Company B 15.5% 58.2% 10.2 2.61
Company C 21.5% 58.0% 10.3 3.60
Referring to these data, which of the following conclusions will be true about the companies’ ROEs?
(a) The main driver of company C’s superior ROE, as compared to that of company A’s and company B’s ROE, is its greater use of debt financing.
(b) The main driver of company C’s superior ROE, as compared to that of company A’s and company B’s ROE, is its efficient use of assets.
(c) The main driver of company C’s superior ROE, as compared to that of company A’s and company B’s ROE, is its operational efficiency.