Under the Du Pont framework of analysis, which of the following relationships is true?
A) Return on assets = return on common equity + capital structure leverage
B) Return on common equity = asset turnover ÷ capital structure leverage
C) Return on common equity = asset turnover × profit margin × capital structure leverage
D) Return on assets = asset turnover + return on equity

Question

Quizplus · Accepted Answer

The Du Pont framework of analysis is used to break down return on equity (ROE) into its components in order to better understand the factors driving it. According to the framework:
ROE = Profit Margin × Asset Turnover × Equity Multiplier
where Equity Multiplier = Total Assets/Total Equity

Rearranging the equation, we get:
Profit Margin × Asset Turnover = ROE/Equity Multiplier

Equity Multiplier can be further broken down into:
Equity Multiplier = 1 + Debt/Equity

Substituting the above expression in the first equation, we get:
ROE = Profit Margin × Asset Turnover × (1 + Debt/Equity)

Simplifying the equation, we get:
ROE = (Net Income/Sales) × (Sales/Total Assets) × (Total Assets/Total Equity + 1)

ROE = (Net Income/Total Equity) × (Total Assets/Sales) × (Sales/Total Assets) × (Total Assets/Total Equity + 1)

ROE = (Net Income/Total Equity) × (Total Assets/Total Equity + 1)

ROE = Return on assets × (Total Assets/Total Equity + 1)

Therefore, using the Du Pont approach, we can see that Return on common equity is calculated as Asset turnover × Profit margin × Capital structure leverage. Option C correctly represents this relationship.

Under the Du Pont Framework of Analysis, Which of the Following