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 Leverage benefits an unnamed corporation, given its ROA.
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 only.
| 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 indiscriminately. 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.
The Dupont Model is useful for assessment of past performance. It is a poor planning tool. Looking at this example, one may be encouraged to employ more and more risk. Of course, as just noted, too much debt is not necessarily a good thing: it increases the risk of becoming insolvent – causing the TIE Ratio to be below one.