Chartered Financial Analyst (CFA) Practice Exam Level 2

What formula describes the DuPont model for ROE?

1. ROE = (NI / Sales) * (Sales / Total Assets) * (Total Assets / Equity)

2. ROE = (Total Assets / Equity) + (NI / EBIT)

3. ROE = NI - (Sales - COGS)

4. ROE = (Sales / Assets) * (NI / Taxes)

The correct answer is: ROE = (NI / Sales) * (Sales / Total Assets) * (Total Assets / Equity)

The DuPont model for Return on Equity (ROE) breaks down this key performance metric into its component parts to understand the interplay between profitability, asset efficiency, and financial leverage. The correct formula for the DuPont model is expressed as: ROE = (Net Income / Sales) * (Sales / Total Assets) * (Total Assets / Equity) This formula indicates that ROE can be dissected into three key ratios: 1. **Net Profit Margin (NI / Sales)**: This ratio reflects how much profit a company generates from its total sales. A higher net profit margin indicates better profitability. 2. **Asset Turnover (Sales / Total Assets)**: This ratio measures how efficiently a company uses its assets to generate sales. Higher asset turnover indicates effective asset management. 3. **Equity Multiplier (Total Assets / Equity)**: This ratio illustrates financial leverage by showing how much of the company's assets are financed through equity. A higher equity multiplier indicates greater leverage, which can enhance ROE if the return from assets exceeds the cost of debt. By multiplying these three ratios, the DuPont model provides a comprehensive view of the factors influencing ROE and allows analysts to identify areas for improvement.