Question

The DUPONT model is useful when examining bank performance because:Select one:a. The ROA equals ROE times Leverage Multiplier.b. The net margin equals the asset utilisation.c. Banks have a similar financial structure as non-finance firms.d. Banks hold a lot of debt and have a small mark up, and the DuPont illustrates this relationship.

Answer 1

Answer:

d. Banks hold a lot of debt and have a small mark up, and the DuPont illustrates this relationship.

Explanation:

The Dupont model is basically a more complex return on equity (ROE) analysis. It breaks down ROE using net profit, asset turnover and equity multiplier (or financial leverage) to focus on the financial performance of businesses.

ROE = profit margin x asset turnover x financial leverage

When firms have higher financial leverage, ROE will increase, but risk will also increase, resulting in higher cost of equity.

Banks tend to have a much higher financial leverage than most companies since their business is to take deposits (liabilities) and then make loans to other clients (assets). E.g. commercial banks on average have a debt to equity ratio of 2, while investment banks have a D/E ratio of 3 or more. That means that for every $1 of equity, investment banks have $3 of debt.

The Dupont analysis is useful for understanding whether a company's performance is based on its efficiency (high profit margin or asset turnover) or its financial leverage. If a high ROE is based solely on a high financial leverage, then the company is considered a risky investment.