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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鈥� 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鈥檚 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

Fill in the blank spaces with categories 1 through 7:

1. Balance sheet (BS)

2. Income statement (IS)

3. Current assets (CA)

4. Fixed assets (FA)

5. Current liabilities (CL)

6. Long-term liabilities (LL)

7. Stockholders鈥� equity (SE)

Indicate whether item is on Balance sheet (BS) or Income statement (IS)

If on Balance sheet, designate which category

Item

Accounts receivable

Retained earnings

Income tax expense

Accrued expense

Cash

Selling and administrative expenses

Plant and equipment

Operating expenses

Marketable securities

Interest expense

Sales

Notes payable (6 month)

Bonds payable, maturity 2019

Common stock

Depreciation expense

Inventories

Capital in excess of par value

Net income (earning after tax)

Income tax payable

The Sterling Tire Company鈥檚 income statement for 20X1 is as follows:

STERLINE TIRE COMPANY

Income Statement

For the year ended December 31, 20X1

Sales (20,000 tires at \(60 each)

\)1,200,000

Less: variable costs (20,000 tires at \(30)

600,000

Less: fixed cost

400,000

Earnings before interest and taxes (EBIT)

\)200,000

Interest expenses

50,000

Earning before taxes (EBT)

\(150,000

Income tax expenses (30%)

45,000

Earning after taxe (EAT)

\)105,000

Given this income statement, compute the following:

b. Degree of financial leverage.

Vriend Software Inc.鈥檚 book value per share is \(15.20. If earnings per share is\)1.88 and the firm鈥檚 stock trades in the stock market at 3.5 times book value pershare, what will the P/E ratio be? (Round to the nearest whole number.)

In January 2007, the Status Quo Company was formed. Total assets were \(544,000, of which \)306,000 consisted of depreciable fixed assets. Status

Quo uses straight-line depreciation of \(30,600 per year, and in 2007 it estimated its fixed assets to have useful lives of 10 years. Aftertax income has been \)29,000 per year each of the last 10 years. Other assets have not changed since 2007.

a. Compute return on assets at year-end for 2007, 2009, 2012, 2014, and 2016.

(Use $29,000 in the numerator for each year.)

The Manning Company has financial statements as shown next, which are representative of the company鈥檚 historical average.

The firm is expecting a 35 percent increase in sales next year, and management is concerned about the company鈥檚 need for external funds. The increase in sales is expected to be carried out without any expansion of fixed assets, but rather through more efficient asset utilization in the existing store. Among liabilities, only current liabilities vary directly with sales.

Using the percent-of-sales method, determine whether the company has external financing needs, or a surplus of funds. (Hint: A profit margin and payout ratio must be found from the income statement.)

Income statement

Sales

\(250,000

Expenses

192,000

Earnings before interest and taxes

\)58,000

Interest

7,500

Earnings before taxes

\(50,500

Taxes

15,500

Earning after taxes

\)35,000

Dividends

\(7,000

BALANCE SHEET

Assets

Liabilities and Stockholder鈥檚 equity

Cash

\)8,500

Accounts payable

\(26,400

Accounts receivable

63,000

Accrued wages

2,350

Inventory

91,000

Accrued taxes

3,750

Current assets

\)162,500

Current liabilities

\(32,500

Fixed assets

85,000

Notes payable

7,500

Long term debts

17,500

Common stock

125,000

Retained earnings

65,000

Total assets

\)247,500

Total liabilities and stockholder鈥檚 equity

$247,500
See all solutions

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