Placing your hard earned money into anything other than your bank account can be a risky move. On the other hand the risk of investing your money could prove to be very lucrative as well. Risk relates to the range of possible outcomes from an activity, the wider the range of possible outcomes the greater the risk. In order to ascertain whether to invest your money or not you must calculate the rate of return. The rate of return would tell you if the investment is a profitable or not. In order to calculate the rate of return you would need to do the following:
Rate of return=Amount of return/ Amount invested (capital).
For example: Let’s say you invest $100 in stock, which is called your capital. One year later, your investment yields $110. What is the rate of return of your investment? It is calculated by using the following formula:
((Return – Capital) / Capital) × 100% = Rate of Return
As a result: (($110 – $100) / $100) × 100% = 10%
Your rate of return is 10%.
There are many financial ratios that are frequently used in the world of business that it is easy to get lost in the shuffle. Using the DuPont Model allows companies to break the firm’s profitability down into component parts to see where it actually comes from. The DuPont Model is an important tool for business’s to use in order to analyze their Return on Investment (ROI) or return on assets. The rate of return calculation is particularly significant because it ultimately describes the rate of return a company is able to receive based on the assets that it had available that year. The expansion of the basic ROI calculation occurred in the late 1930’s by financial analysts at E.I DuPont de Nemours & Co. The theory came into practice when it was found that profitability from sales and the utilization of assets to generate revenue were both the important factors when assessing a company’s overall profitability.
The more widely used variation of the ROI calculation is as following:
Return on Investment= Net income /Sales X Sales/Average total assets = ____%
Initially, look at the company’s ROI which is: ROI = Net Income/Total Assets = _____%. Below are the steps using the DuPont Model to calculate both return on investment and return on equity.
ROI = Net Income/ Average total Assets = _____%. The net income is taken directly from the company income statement and average total assets are taken from the company’s balance sheet. Ultimately this ratio tells you how well you have been using your assets to produce sales.
The percentage doesn’t really tell you much but you can break the percentage down more to give valuable information. To do that, you can must use the DuPont Model and break down the ROI into its component parts. ROI will look like this:
ROI = Net Income/Sales X Sales/Total Assets =
Within this equation Net Income/Sales is the net profit margin and comes from the income statement and Sales/Total Assets is the Total Asset Turnover and sales come from the income statement and average total assets comes from the balance sheet.
ROI is composed of two parts: the company’s profit margin and asset turnover or its 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 the same way.
ROE = Net income /Average owners equity = _____%.Net Income comes from the income statement and Common Equity is the sum of all the equity accounts on the balance sheet.
It is important to keep in mind that ROI can be increased by any of the following actions: increasing sale and/or reducing expenses. The DuPont model is an approach that allows managers to specifically focus on increasing sales, while controlling costs and being aware of the amount invested in productive assets. A comprehensive financial statement analysis will provide insights as to a firm’s performance and/or standing in the areas of liquidity, operating efficiency and profitability. Time series analysis will examine trends using the firm’s own performance as a benchmark.