Decomposition of Profitability into Financing, Investing and Operating Leverages Components and the Overstatement of Return on Net Operating Assets

Abstract

The original and the advanced Du Pont models fail to account for the contributions of financing, investing and operating activities of the firm to profitability distinctly. The original Du Pont specifies return on equity to be a multiplicative component of profit margin (efficiency of operations), asset turnover (efficiency of assets) and Equity multiplier (financial leverage). The advanced Du Pont model decomposed return on equity into operating profitability and financing profitability components namely, return on net operating assets and return on net financial obligations. We derive the additive three leverages Du Pont model that isolate the profit attributable to financing, investing and operating leverages. Financing leverage component of return on equity comprises two elements. The first element is the portion of profit arising from the use of debt-financed current assets (efficiency of operations). The second element is the portion of profit due to the capacity of debt-financed non-current assets to generate income (efficiency of assets); the operating leverage component of return on equity (ROE)is the part that is due to the use of current assets and current liabilities (working capital) in operations (both efficiency of operations and efficiency of assets). The investing leverage component of ROE is the profit attributed to the capacity of equity-financed non-current assets to generate income (efficiency of assets). This paper contributes to knowledge by distinctly identifying and accounting for investing leverage. When applied to the data in Burns, Sale & Stephan (2008), we show that debt financing boosts the capacity of investment in assets and that the advanced Du Pont model overstates return net operating assets.