DuPont Equation

RoE = Net Income / Shareholders Equity

=(Net Income / Sales Revenue ) X (Sales Revenue / Total Assets ) X (Total Assets /
Share holders Equity )
= Net Profit Margin X Asset Turnover X Financial Leverage
Above Dupont Equation shows break up of RoE in to three components. This helps
to identify what driver is actually pushing RoE to move. If Net Profit Margin has
changed it means company has taken control of its revenue and expenses. For any
given level of sales, the net profit margin is higher if expenses are lower and lower if
expenses are higher.
If Asset Turnover is high it means company is using its assets effectively to produce
finished products and hence realize sales revenue. Year on Year Benchmarking
within the firm and at the same time comparison with Industry helps to understand
the performance of this indicator.
Financial Leverage is seen as most dubious component of the equation. Firm
typically use this to project high RoE. Hence if Financial Leverage has only caused
RoE to increase, this is not sees as sustainable mode.
As a CFO of a firm, I would like to monitor all the three components. However
Financial Leverage is one of the components which is completely a domain of
finance department. Other two components are more of operational parameters.

Dear Jason,
You are right DuPont Equation was formulated to examine fundamental drivers of
profitability. It would have been better if you could mention the importance and role
of each of the components in equation. However I agree with your opinion that one
should look for consistency in each of parameters determining operational and
financial strength.

Dear Bradon,
You have explained very well the importance and role of each of the components in
DuPont equation. In my opinion, financial leverage component is a place where I
have seen major changes year on year to maintain consistent return on Equity.
Moreover , as a CFO, one would monitor at all three parameters of DuPont Equation
and see the effect of year wide decisions taken, operations undergone .