LOS D requires us to:
demonstrate the application of DuPont analysis of return on equity and calculate and interpret effects of changes in its components.
a. Through DuPont Analysis, the analyst breaks down the return on equity into three different components, in order to identify the superior source of return.
b. The formula for calculating ROE is:
Now, ROE can also be measured as a product of return on assets and leverage ratio, i.e.
Or,
Here there is a common numerator and denominator; hence it cancels out making the outcome remaining the same.
c. We can further decompose the return on assets into net profit margin and total assets turnover.
Also,
Or,
d. Thus, we can decompose the return on equity into three different components, i.e. net profit margin, total assets turnover, and leverage.
Or,
e. This was a simple decomposition of ROE for the DuPont Analysis. This equation can similarly, further be decomposed into a 5-way DuPont equation, which is:
i.e.,
f. These decompositions help in identifying clearly, as to what are the factors that prime in reducing or increasing the return to the shareholders. Thus with the help of decomposed ROE statement:
i. we can identify the tax burden and plan a better tax strategy,
ii. interest burden can be identified to plan better solvency,
iii. identify the operating margin for better cost management,
iv. efficiency and leverage will help in making decisions with regards to an optimal CAPEX