Financial Statement Analysis
Diagnose return on equity
Two businesses earn the same return on equity. Which one relies more on leverage?
DuPont analysis decomposes return on equity into profit margin, asset turnover and the equity multiplier.
ROE = net income ÷ sales × sales ÷ average assets × average assets ÷ average equity
Cancel sales and average assets from the middle terms to get net income divided by average equity. 8% × 1.25 × 2 = 20%.
Sales ₹200 lakh, net income ₹16 lakh, average assets ₹160 lakh and average equity ₹80 lakh. 8% margin × 1.25 asset turnover × 2 equity multiplier = 20% ROE.
Cancel sales and average assets from the middle terms to get net income divided by average equity. 8% × 1.25 × 2 = 20%.
Margin falls to 6% while turnover remains 1.25 and the equity multiplier rises to 3. What happens to ROE?