# This is easily one of my favourite financial frameworks because it is so useful and intuitive, a great combination.

Even if you had a limited math background using common sense you could probably reproduce this formula (either from the bottom up or top down). Let's do it top down as it's presented in the CFA text books:

Return on Equity (RoE) = Net Income (NI) / Equity or Return on Equity = Return on Assets (RoA) x Financial Leverage (FLA) and RoA = NI / Assets and FLA = Assets / Equity

At each stage, the formula can be further decomposed. For instance, Return on Assets can be decomposed to: RoA = Net profit margin (NPM) x Total Asset Turnover This formula captures the essence of operational efficiency in terms most lay people can understand. How[efficiently] are we selling (Total Asset Turnover - TAT) [with respect to the assets we use to produce our product - directly related to revenue and number of products sold at a constant price]? The DuPont model goes on to further decompose NPM as gross produ margin, tax ct burden and effect of 'non-operating items' etc, but even at this stage, this formula gives a good basis for common size comparison with other companies in the industry. Let's look at each component and see if we can describe them in layman' terms: s
y y

Return on Equity - How much income are we making relative to the equity we put in? Financial leverage - How much debt have we applied relative to our equity?

Before we do accounting and pay tax.Can we use depreciation and amortization to affect our tax burden? n y u ng Net Profit Margin . You've got Asset Turnover wrong. CFA. It is the Firms use of assets to create revenue. how much of each good or service do we keep for each sale? Tax burden .How muc income are we making relative to all the capital we put it (including debt)? Total Asset Turnover . the high er the revenue and the higher the total asset turnover (assuming the same asset value). operational efficiency and sales to identify if there are problems from a high level to determine if certain areas warrant a deeper investigation. No calculus required. Holding price for each unit the same. I had previously said that Total Asset Turnover was "How much product is sold". I've made the corrections in bold. after the costs.How [ ff much do we keep? Gross Profit Margin .After accounting practices. Thanks for the clarification. This isn't entirely accurate. the higher the number of units sold. I was trying to illustrate the directly proportional relationship between hig h sales numbers and high revenue (which would result in a higher Total Asset Turnover) assuming a constant price. Posted by Joshua Wong at 7:07 AM Labels: Accounting.. how It can quickly tell you the status of the leverage. Valuation 3 commen : Anonymous said. 2009 1:31 PM Joshua Wong said. June 3. I have over simplified my statement.. 2009 1:53 PM ©¤¡©©¦ §  u © ¡¨ ¡§ ¦ ¥ ¤ ¡ £ ¡ ¢ ¢ ¢   ]?  . June 3.y y y y y y Return on Assets . The TAT ratio is calculated as Revenue over Total Assets...For each unit of good or service we sell. what is the effect of our current tax rate? Non-operating items .

And just to be clear: I wanted to make a distinction between adjusting the capital structure and selling more units (in terms of how lay people think of business and management decisions). 2009 1:59 PM .Joshua Wong said. Then the only way to change ROA for a constant value of assets is to increase sales.. That is to say that Assets would only really change through the capital structure and leverage component (FLA) assuming a constant equity (by increasing debt). Hope that justifies my oversimplification :) June 3..