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## Return on Investment: Putting the DuPont Model Into Practice

Putting your hard-earned money into anything other than your bank account can be risky. On the other hand, the risk of your investment may prove to be very profitable. Risk is related to the range of possible outcomes from an activity, the wider the range of potential outcomes the greater the risk. In order to be sure whether you are investing your money or not you need to calculate the rate of return. The rate of return will tell you whether the investment is profitable or not. To calculate the rate of return you will need to do the following:

Rate of return = Rate of return/ Amount invested (capital).

Example: Let’s say you invest $100 in a stock, called your equity. One year later, your investment yields $110. What is the rate of return on your investment? It is calculated using the following formula:

((Return – Capital) / Capital) × 100% = Rate of Return

Therefore: (($110 – $100) / $100) × 100% = 10%

Your rate of return is 10%.

There are so many financial ratios used so often in the business world that it’s easy to get lost in the print. Using the DuPont Model allows companies to break down a firm’s profitability into components to see where it comes from. The DuPont Model is an important tool that businesses can use to analyze their Return on Investment (ROI) or return on assets. The rate of return calculation is very important because it ultimately defines the rate of return that the company is able to earn based on the assets it had that year. The expansion of the basic ROI calculation occurred in the late 1930s by financial analysts at EI DuPont de Nemours & Co. The theory began to work when it was discovered that profits from sales and the use of assets to generate income were both important factors when. Assessing the company’s overall profitability.

The most commonly used ROI calculation variables are as follows:

Return on Investment = Net Income/Sales X Sales/Average Total Assets = ____%

First, look at the company’s ROI: ROI = Net Income / Total Assets = _____%. Below are steps that use the DuPont Model to calculate both return on investment and return on equity.

ROI = Return on Income/ Average Return on Assets = _____%. Net income is taken directly from the company’s income statement and average total assets are taken from the company’s balance sheet. Ultimately this metric tells you how well you’ve been using your assets to generate sales.

The percentage doesn’t tell you much but you can break the percentage further to provide valuable information. To do that, you can use the DuPont Model and break down ROI into its components. The ROI will look like this:

ROI = Revenue / Sales X Sales / Total Assets =

Within this equation Net Income/Sales is the margin of net profit and appears on the income statement and Sales/Total Assets is the Movement in Total Assets and Sales appears on the income statement and average total assets appear on the balance sheet.

ROI is made up of two components: the company’s profit margin and asset turnover or the ability to generate profit and make sales based on its asset base. The extended DuPont Model allows a company to examine Return on Equity (ROE) in a similar way.

ROE = Net income / Average owners’ equity = _____%.Net income appears on the income statement and Common Equity is the sum of all equity accounts on the balance sheet.

It is important to remember that ROI can be increased by any of the following actions: increasing sales and / or reducing costs. The DuPont model is an approach that allows managers to focus directly on increasing sales, while controlling costs and understanding capital invested in productive assets. A comprehensive financial statement analysis will provide insight into the firm’s performance and/or standing in the areas of liquidity, efficiency and profitability. Time series analysis will examine trends using the firm’s performance as a benchmark.

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