Asset utilization financial leverage the basic dupont

Info icon This preview shows pages 26–28. Sign up to view the full content.

View Full Document Right Arrow Icon
(asset utilization) Financial leverage
Image of page 26

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
The basic DuPont model disaggregates ROE as follows: Net income Net income Sales Average total assets ROE = = x x ------"'------ Average stockholders' equity Sales Average total assets Average stockholders' equity t t t Financial Leverage (FL) 3-27 Module 3 I Profitability Analysis and Interpretation Each of these measures is generally positive, in which case an increase in anyone would increase ROE. A focus on these measures encourages managers to focus on both the balance sheet and the income statement. Such an analysis typically examines each of these components over time. Managers then seek to reverse adverse trends and to sustain positive trends. Basic DuPont Model Profit Margin (PM) Asset Turnover (AT) These three components are described as follows: Profit margin is the amount of profit that the company earns from each dollar of sales. A company can increase its profit margin by increasing its gross profit margin (Gross profit/Sales) and/or by reducing its expenses (other than cost of sales) as a percentage of sales. Asset turnover is a productivity measure that reflects the volume of sales that a company generates from each dollar invested in assets. A company can increase its asset turnover by increasing sales volume with no increase in assets and/or by reducing asset investment without reducing sales. Financial leverage measures the degree to which the company finances its assets with debt rather than equity. Increasing the percentage of debt relative to equity increases the financial leverage. Although financial leverage increases ROE (when performance is positive), debt must be used with care as it increases the company's relative riskiness (see our following discussion of financial leverage). Return on Assets The first two terms in the DuPont model, profit margin and asset turnover, relate to company operations and com- bine to yield return on assets (ROA) as follows: Net income ROA=------ Average total assets Net income ----x Sales Sales Average total assets Return on assets combines the first two terms in the ROE disaggregation, profit margin and turnover. It measures the return on investment for the company without regard to how it is financed (the relative proportion of debt and equity in its capital structure). Operating managers of a company typically grasp the income statement. They readily understand the pricing of products, the management of production costs, and the importance of controlling overhead costs. However, many managers do not appreciate the importance of managing the balance sheet. The ROA approach to performance measurement encourages managers to also focus on the returns that they achieve from the invested capital under their control. Those returns are maximized by ajoint focus on both profitability and productivity.
Image of page 27
Image of page 28
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern