If you were a manager of a company, which of the three right side components of the DuPont Identity would you want to increase and which would you want to decrease, other things being equal? Give a specific example for how to do that for each of the three.

Ans:

The DuPont Identity measures the company’s ROE in terms of its profitability, asset efficiency, and leverage. The model helps investors compare similar companies like these with similar ratios. Investors can then apply perceived risks with each company’s business model. Based on these three performances measures i.e. Profit Margin, Total Asset Turnover and Financial Leverage, the model concludes that a company can raise its ROE by maintaining a high profit margin, increasing asset turnover, or leveraging assets more effectively. The first term in the DuPont Identity is the firm’s net profit margin, which measures its overall profitability. The second term is the firm’s asset turnover, which measures how efficiently the firm is utilizing its assets to generate sales. Together, these terms determine the firm’s return on assets. The third term is the equity multiplier which indicates the value of assets held per dollar of shareholder equity. The right side components of the DuPont Identity that can be increased are Net Income and sales. The inventory and account receivable can be reduced which can help the current assets position and in turn   reduces total assets, which then improves total asset turnover. I would like to decrease the inefficiencies in asset utilization and inventory holding to improve the ROE. If investors are unsatisfied with a low ROE, the management can use this formula to pinpoint the problem area whether it is a lower profit margin, asset turnover, or poor financial leveraging.

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