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Chapter 2: 2DQ (page 74)

Explain how the Du Pont system of analysis breaks down return on assets. Also explain how it breaks down return on stockholders’ equity

Short Answer

Expert verified

With the Du Pont system of analysis, the return on assets is calculated by multiplying the net profit margin with the total assets turnover. And the return on the stockholder’s equity is calculated by multiplying the return on the asset with the equity multiplier.

Step by step solution

01

Definition

The Du Pont analysis breaks down the equation of Return on Equity (ROE) into three parts:

  • Profitability is measured by the profit margin (Net income/Revenue)
  • Asset efficiency is measured by asset turnover(Revenue/Average Total Assets)
  • Financial leverage is measured by the equity multiplier(Average Total Assets/Average Total Equity)

02

 By the Du Pont system, return on assets is broken down as

03

By the Du Pont system, the return on stockholder’s equity is broken down as

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Most popular questions from this chapter

Why is trend analysis helpful in analyzing ratios?

Inflation can have significant effects on income statements and balance sheets, and therefore on the calculation of ratios. Discuss the possible impact of inflation on the following ratios, and explain the direction of the impact based on your assumptions.

b. Inventory turnover

What is free cash flow? Why is it important to leveraged buyouts?

For December 31, 20X1, the balance sheet of Baxter Corporation was as follows:

Current assets

Liabilities

Cash

\(15,000

Accounts payable

\)17,000

Accounts receivable

20,000

Notes payable

25,000

Inventory

30,000

Bonds payable

55,000

Prepaid expenses

12,500

Fixed assets

Stockholder’s equity

Plant and equipment (gross)

Less: accumulated depreciation

\(255,000

51,000

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Net plant and equipment

\(204,000

Common stock

60,000

Paid in capital

30,000

Retained earnings

69,500

Total assets

\)281,500

Total liabilities and stockholder’s equity

\(281,500

Sales for 20X2 were \)245,000, and the cost of goods sold was 60 percent of sales. Selling and administrative expense was \(24,500. Depreciation expense was 8 percent of plant and equipment (gross) at the beginning of the year. Interest expense for the notes payable was 10 percent, while the interest rate on the bonds payable was 12 percent. This interest expense is based on December 31, 20X1 balances. The tax rate averaged 20 percent.

\)2,500 in preferred stock dividends were paid, and \(5,500 in dividends were paid to common stockholders. There were 10,000 shares of common stock outstanding.

During 20X2, the cash balance and prepaid expenses balances were

unchanged. Accounts receivable and inventory increased by 10 percent. A new machine was purchased on December 31, 20X2, at a cost of \)40,000. Accounts payable increased by 20 percent. Notes payable increased by \(6,500 and bonds payable decreased by \)12,500, both at the end of the year. The preferred stock, common stock, and paid-in capital in excess of par accounts did not change.

a. Prepare an income statement for 20X2.

Easter Egg and Poultry Company has \(2,000,000 in assets and \)1,400,000 of debt. It reports net income of $200,000.

c. If the firm has an asset turnover ratio of 2.5 times, what is the profit margin

(return on sales)?
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