Intermediate problem – Foundations of Financial Management
#16 – Du Pont system of analysis
Jerry Rice and Grain Stores has $4,000,000 in yearly sales. The firm earns 3.5 percent
on each dollar of sales and turns over its assets 2.5 times per year. It has $100,000 in
current liabilities and $300,000 in long-term liabilities.
a. What is its return on stockholders’ equity?
b. If the asset base remains the same as computed in part a, but total asset turnover goes
up to 3, what will be the new return on stockholders’ equity? Assume that the profit
margin stays the same as do current and long-term liabilities.
16. Solution
Sales = $4,000,000
Profit margin = 3.5%
Total asset turnover = 2.5
Current liabilities = $100,000
Long-term liabilities = $300,000
a. Calculation of the Total assets
Total asset turnover = Sales / Total assets
Total assets = Sales / Total asset turnover
Total assets = $4,000,000 / 2.5
Total assets = $1,600,000
Calculation of the Return on assets
Return on assets = Profit margin × Asset turnover
Return on assets = 3.5% × 2.5 or 0.035 × 2.5
Return on assets = 0.0875 or 8.75%
Calculation of the Total liabilities
Total liabilities = Current liabilities + Long-term liabilities
Total liabilities = $100,000 + 300,000
Total liabilities = $400,000
Its return on stockholder’s equity is:
Return on equity = Return on assets / (1 – Debt / Assets)
Return on equity = 0.0875 / (1 – $400,000 / 1,600,000)
Return on equity = 0.0875 / (1 – 0.25)
Return on equity = 0.0875 / 0.75
Return on equity = 0.1167 or 11.67%
b. Total asset turnover = 3
Calculation of the new Return on assets
Return on assets = Profit margin × Asset turnover
Return on assets = 0.035 × 3
Return on assets = 0.105 or 10.5%
Its return on stockholder’s equity will be:
Return on equity = Return on assets / (1 – Debt / Assets)
Return on equity = 0.105 / (1 – $400,000 / 1,600,000)
Return on equity = 0.105 / (1 – 0.25)
Return on equity = 0.105 / 0.75
Return on equity = 0.14 or 14%