Return on Equity (ROE) The amount of net income returned as a percentage of shareholders equity.

Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. ROE is expressed as a percentage and calculated as: Return on Equity = Net Income/Shareholder's Equity Net income is for the full fiscal year (before dividends paid to common stock holders but after dividends to preferred stock.) Shareholder's equity does not include preferred shares. An expression that breaks return on equity (ROE) down into three parts: profit margin, total asset turnover and financial leverage. It is also known as "DuPont Analysis". DuPont identity tells us that ROE is affected by three things: - Operating efficiency, which is measured by profit margin - Asset use efficiency, which is measured by total asset turnover - Financial leverage, which is measured by the equity multiplier ROE = Profit Margin (Profit/Sales) * Total Asset Turnover (Sales/Assets) * Equity Multiplier (Assets/Equity)

Why Return on Equity Is Important A business that has a high return on equity is more likely to be one that is capable of generating cash internally. For the most part, the higher a company's return on equity compared to its industry, the better. This should be obvious to even the less-than-astute investor If you owned a business that had a net worth (shareholder's equity) of $100 million dollars and it made $5 million in profit, it would be earning 5% on your equity ($5 ÷ $100 = .05, or 5%). The higher you can get the "return" on your equity, in this case 5%, the better.

While ROE is a useful measure, it does have some flaws that can give you a false picture, so never rely on it alone. For example, if a company carries a large debt and raises funds through borrowing rather than issuing stock it will reduce its book value. A lower book value means you¶re dividing by a smaller number so the ROE is artificially higher. There are other situations such as taking write-downs, stock buy backs, or any other accounting slight of hand that reduces book value, which will produce a higher ROE without improving profits. It may also be more meaningful to look at the ROE over a period of the past five years, rather than one year to average out any abnormal numbers.

The DuPont formula. a retailer of water sporting goods. Profitability: Net Profit Margin (NPM: Net Income/Sales) . again resulting in a higher overall ROE. So if the firm takes on too much debt. 2.Given that you must look at the total picture. if the net margin increases. Finally. Essentially. arguably the most important of the key ratios. ROE will equal the net margin multiplied by asset turnover multiplied by financial leverage. Similarly. While the DuPont analysis is not an adequate replacement for detailed financial analysis. as represented in equation (1). the company that can consistently squeeze out more profits with their assets. ROE is a useful tool in identifying companies with a competitive advantage. Inc. and ROE decreases. if the asset turnover increases. it provides an excellent snapshot and starting point. therefore. operating efficiency and leverage (liquidity analysis needs to be conducted separately). increasing financial leverage means that the firm uses more debt financing relative to equity financing. and 3). also known as the strategic profit model. we examine the meaning of each of these components by calculating and comparing the DuPont ratio using the financial statements and industry standards for Atlantic Aquatic Equipment. Financial leverage benefits diminish as the risk of defaulting on interest payments increases. (Exhibits 1. A for-profit business exists to create wealth for its owner(s). Interest payments to creditors are tax deductible. For example. but dividend payments to shareholders are not. The three components of the DuPont ratio. Splitting return on equity into three parts makes it easier to understand changes in ROE over time. since it indicates the rate at which owner wealth is increasing. is a common way to break down ROE into three important components. Thus. In the following paragraphs. ROE is. will be a better investment in the long run. a higher proportion of debt in the firm's capital structure leads to higher ROE. every sale brings in more money. the firm generates more sales for every unit of assets owned. as will be seen below. All other things roughly equal. [2] Increased debt will make a positive contribution to a firm's ROE only if the matching Return on assets (ROA) of that debt exceeds the interest rate on the debt. resulting in a higher overall ROE. cover the areas of profitability. [3] The DuPont Ratio Decomposition The DuPont ratio is a good place to begin a financial statement analysis because it measures the return on equity (ROE). the cost of debt rises as creditors demand a higher risk premium.

The cross sectional comparison can be drawn from a variety of sources. the gross profit margin measures the difference between sales revenue and the cost of goods actually sold during the accounting period. Operating Ficiency or Asset U tion: Total Asset Turnover (TAT: Sales/Average Assets) Turnover or efficiency ratios are important because they indicate how well the assets of a firm are used to generate sales and/or cash.Profitability ratios measure the rate at which either sales or capital is converted into profits at different levels of the operation.22%. net profitability is the most comprehensive since it uses the bottom line net income in its measure. which may not always be the case.782. Income statement items are flow variables measured over a time interval. Most common are the Dun & Bradstreet Index of Key Flnancial Ratios and the Robert Morris Associates (RMA) Annual Statement Studies. working capital turnover. The net profitability for Atlantic Aquatic Equipment in 1996 is: Net Profit Margin = Net Income/Sales = $70. (2) A proper analysis of this ratio would include at least three to five years of trend and crosssectional comparison data. . Taking a simple average for balance sheet items (i. A firm with abnormally large inventory balances is not performing effectively. As in the case of net profitability..e. While profitability is important. Goods produced but not sold will show up as inventory assets at the end of the year. operating and net profitability. inventory and receivables turnover). such as an expansion project. The goods sold may be entirely different from the goods produced during that same period. It is important to use average assets in the denominator to eliminate bias in the ratio calculation. In cases where the firm has been involved in major change. balance sheet measures taken at the end of the year may misrepresent the amount of assets available and/or in use over the course of the year. ((beginning ending)/2)) will control for at least some of this bias and provide a more accurate and meaningful ratio.530/$5. it doesn't always provide the complete picture of how well a company provides a product or service. but not too efficient. Each of these volumes provide key ratios estimated for business establishments grouped according to industry (i. TAT uses income statement sales in its numerator and balance sheet assets in the denominator. More will be discussed in regard to comparisons as our example is continued below. The total asset turnover (TAI) ratio measures the degree to which a firm generates sales with its total asset base. Such measures are generated using the matching principle of accounting.000 = 1. Financial ratio bias is commonly present when combining items from both the balance sheet and income statement. and the purpose of efficiency ratios is to reveal that fact. which describe performance at different activity levels. Hence. SIC codes).. Profitability is based upon accounting measures of sales revenue and costs. For example. Of the three. The most common are gross. the most comprehensive measure of performance in this particular area is being employed in the DuPont ratio (other measures being fixed asset turnover. which records revenue when earned and expenses when incurred. A company can be very profitable. The limiting assumption is that the change in the balance sheet occurred evenly over the course of the year.e. while balance sheet items are measured at a fixed point in time.

as follows: Average Assets/Average Equity = 1/(1 -(Average Debt/Average Assets)).31 = 6. and therefore. while equation (5) uses the well known debt/equity ratio. as follows: (Net Income/Sales)X(Sales/Average Assets)X(Average Assets)X(Average Assets/Average Equity) = ROE 1. Adding debt creates a fixed payment required of the firm whether or not it is earning an operating profit.22% X 2. and therefore. total assets did not substantially change over the course of the year. the risk of the equity position is increased by the presence of debt holders having a superior claim to the assets of the firm.96%.200)/2)= 2. Leverage: The Leverage Multiplier (Average Assets/Average Equity) Leverage ratios measure the extent to which a company relies on debt financing in its capital structure. Further.The measure of total asset turnover for Atlantic Aquatic Equipment is: TAT = Sales/Average Assets= $5.982)/2) = 2.000/(($2. (3) In this case.782. The leverage multiplier employed in the DuPont ratio is directly related to the proportion of debt in the firm's capital structure. which divides average assets by average equity. The leverage multiplier for Atlantic Aquatic Equipment is: Average Assets/Average Equity = $2. The cost of debt is lower than the cost of equity. (7) .47.700/(($995. averages are used to control for potential bias caused by the endof-year values.476.47 X 2." The debt sword.025. however.31.652 $1. owners keep the residual. Once again. If debt proceeds are invested in projects which return more than the cost of debt. payments may cut into the equity base. the return on equity is "leveraged up. they can be combined to form the ROE.203. it is a good idea to get into the habit of using averages for all balance sheet items when conducting this type of analysis. cuts both ways. an effect which is enhanced by the tax deductibility of interest payments in contrast to taxable dividend payments and stock repurchases. or Average Assets/Average Equity = 1 (Average Debt/Average Equity =1 (Average DebtlAvernge Equity). (S) Equation (4) employs a simple debt/asset ratio.339. can be restated in two ways. Regardless. potential bias caused by using the ending asset amount would not be substantial. and hence. Debt is both beneficial and costly to a firm. The measure.(6) Combination and Analysis of the Results Once the three components have been calculated.200 $2.

In any case. on the other hand. however. The DuPont ratio for the industry (Exhibit 4) is: 3.60% X 2. understanding of the true performance of the firm would be lost. while total asset turnover and leverage seem to be roughly in line with the industry. The analyst can now focus on the company's profitability. while not the end in itself. The next step in the analysis would most likely be a qualitative study of the composition of the inventory as well as the retail facility itself. By identifying strengths and/or weaknesses in any of the three areas. an average outcome for net profitability may mask the existence of a low gross margin combined with an abnormally high operating margin. the DuPont can add value. Profit margin indicates how efficient the company¶s management is in operating the company and in controlling costs. The company appears to have a significant weaknesses in profitability. total assets is the most broad of asset measures). there may be problems that the DuPont decomposition does not readily identify. measures the efficiency of the company in generating sales for every . Further. even "on the fly. drawing from the broadest values on the balance sheets and income statements (e.60 X 2.. A DuPont study is not a replacement for detailed. comprehensive analysis. operating efficiency and leverage. this result is not meaningful until it is compared to an industry or best practices benchmark.00 = 18. Some caveats. Concluding Remarks Sound financial statement analysis is an integral part of the management process for any organization. The DuPont ratio. problems in Atlantic Aquatic Equipment are immediately evident in the comparison of equations (7) and (8). A quick analysis of profitability yields the following result: As can be seen.While additional measures for prior years would provide the basis for a necessary trend analysis. the inventory turnover is significantly lower than the industry average. are to be noted.g. For example. Asset turnover. The DuPont ratio can also be broken into more components. profitability. depending upon the needs of the analyst. the DuPont analysis enables the analyst to quickly focus his or her detailed study on a particular spot. making the subsequent inquiry both easier and more meaningful. which means that the problem is more likely due to poor location or inventory quality rather than the inventory management processes." to understand and solving a broad variety of business problems. is an excellent way to get a quick snapshot view of the overall performance of a firm in three of the four critical areas of ratio analysis. The DuPont ratio consists of very general measures.72% (8) As can be seen. Without looking at the two detailed measures.

investment analysis tool in deciding on what stock to include in a portfolio. stock investment analysis should be taken very seriously . are just few of numerous financial tools that an investor can easily use in investment analysis. Other tools such as the return on investment and cash flows as a percentage of sales. the DuPont ratio and return on equity.dollar of asset. You are also committing a part of your dream of becoming financially independent. Lastly. but what contributed to their ROEs should also be analyzed. or any other income statement item. Of course. Using the DuPont system in evaluating alternative stock investments helps investors in comparing why ROEs of these stocks differ by identifying the impact of operating efficiency. for that matter. should not be used as the sole. asset-use efficiency and financial leverage on the return on equity. Buying a stock is a serious commitment. the equity multiplier shows how leveraged a company is by computing how much financing stockholders provided for every dollar of asset. You are committing a portion of your wealth. Hence. It is not enough that each of these stock investment alternatives be ranked according to ROEs.

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