Be prepared to discuss profitability, using the tools of DuPont Analysis: ROA-ne

Question

Be prepared to discuss profitability, using the tools of DuPont Analysis: ROA-net profit margin x total asset turnover ROE ROA x (total assets/ shareholder's equity) This means that you should be prepared to explain how changes in profit margins and asset efficiency affect profitability (as measured by ROA), using examples It also means that you should be able to explain how a change in the mix of debt vs equity financing will affect ROE (and also risk) Note: you should also understand how these profitability measures differ from our NPV-based measures of value creation

Explanation / Answer

As the concept of applying the leverage towards appreciation of return to the Equity, the inclusion of debt to the capital structure should be there as long as cost of debt is lower to the return on capital. So, the increase in the debt /Equity ratio would be taken place till the time there is a increase in return to per equity unit. For example, if Return on capital is 20%, we keep on applying debt to the capital structure till the time cost of debt is 19% because 1% is being contributed towards the equity.

The profitability concept is different from that of NPV based measurement of return because under profitability we considers all the revenue and costs, whether cash or noncash based, to reach out to the Net Income. Whereas , the NPV based measurement of return we considers only the cash based transactions only.

As per the equation :

ROE = ROA x (total assets / Shareholder’s equity)

= (Net profit margin X total asset turnover) x (total assets / Shareholder’s equity)

= (Net profit margin X Turnover/total assets) x (total assets / Shareholder’s equity)

= (Net profit margin X Turnover / Shareholder’s equity)

= (Net Income / Shareholder’s equity) = ROE

So, it implies that higher the total assets performance will provide higher return to the equity. Also, higher the debt content as per the Leverage concept, provides higher return to the equity but also increase the risk of fixed cost capital in the Capital Structure of the company.

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