6.4: What Does the Dupont Model Show Us?
The Dupont Model enables us to locate the sources of corporate performance . Imagine you are CEO and have to report performance to shareholders.
First, looking top-down, you are interested in ROE. The model shows us the effect of leverage on ROE, given the prior level of ROA.
Then, it ascribes operating performance, as defined by ROA, as being attributable to Profit Margin and Total Asset Turnover. This enables executives to locate areas of weakness within the firm and address them.
Let’s illustrate how this works for an unnamed corporation.
Let’s assume the following:
| Debt = $700 |
| Equity = $300 |
| Total Assets = $1,000 |
| Net Income = $100 |
Therefore:
| ROA = NI / TA = 100 / 1,000 = 0.10 |
| Leverage = Total Assets / Equity = 1,000 / 300 = 3.34 |
| ROE = ROA x Leverage = (0.10) (3.34) = 0.34 |
Leverage has increased the corporation’s ROE!
Alternatively, let’s say the company has no leverage, but the same in Total Assets. In other words, the assets are financed in full by equity.
| ROA = 100 / 1,000 = 0.10 |
| Leverage = 1,000 / 1,000 = 1.0 |
| ROE = (0.10) (1.0) = 0.10 |
Without any Leverage at all , ROE = ROA.
Of course, Leverage is not something that the company should employ indiscr imina t e ly . Too much debt will raise interest expense to possibly unsustainable levels and thus could have a weakening effect on the TIE ratio, leading eventually to insolvency and bankruptcy – in the worst case . The DuPont Model does not address this risk.