Chapter 8, Problem 1MCQ

To determine

Identify the component which is not included in the DuPont analysis of return on equity (ROE).

Answer to Problem 1MCQ

Option b. Inventory turnover is not included in the DuPont analysis of return on equity (ROE).

Explanation of Solution

DuPont analysis of return on equity (ROE):

The DuPont ratio is one of the popular methods for analyzing performance and ratios. The DuPont ratio was derived by the Corporation D for measuring the performance of the entity in the form of return on equity ratio. The DuPont analysis breaks the return on equity into three different types of ratios which are:

• Profit margin or profitability
• Asset turnover or activity ratio
• Financial leverage or solvency ratio

$\begin{array}{c}Returnonequity\left(ROE\right)=\left(\begin{array}{l}Profitmargin\times Operatingleverage\\ \left(orAssetturnover\right)\times Financialleverage\end{array}\right)\\ =\left(\begin{array}{l}\left(Netprofit/Sales\right)\times \left(Netprofit/Sales\right)\\ \left(Sales/Averagetotalassets\right)\times \left(\begin{array}{l}Averagetotalassets\\ /Averageequity\end{array}\right)\end{array}\right)\end{array}$

Justification for correct and incorrect answer:

a.

Asset turnover: This is not the correct choice as the asset turnover is one of the components which are included in the DuPont analysis of return on equity (ROE). It denotes the operating leverage.

b.

Inventory turnover: This option is the correct option because the inventory turnover ratio is not one of the components which are included in the DuPont analysis of return on equity (ROE).

c.

Financial leverage: This option is incorrect because the financial leverage is one of the components which are included in the DuPont analysis of return on equity (ROE). It denotes the solvency of the organization.

d.

Profit margin: This is an incorrect option because the profit margin is included in the DuPont analysis which is used for the profitability of the entity.