Return on Equity (RoE) = Net profit margin X Asset turnover X leverage
Net profit/ Equity = Return on Asset ( Net profit / Sales X Sales/Fixed Assets ) X Total assets/Equity
RoE = Return on Assets (RoA) X Total Assets/ Equity
Breaking the RoE into these three parts allows evaluation of how well the company manages its:
A manager has basically three ways of improving operating performance in terms of Return on Assets (ROA) and Return on Equity (ROE). These are:
- Increase operating profit margins - Control expenses
- Increase capital asset turnover - Increase Asset Productivity
- Change financial leverage - Use debt capital for higher RoE as long as RoCE is higher then cost of capital.
Each of these primary drivers is impacted by the specific decisions on cost control, efficiency productivity, marketing choices etc .
Importance of Dupont Analysis
Any decision affecting the product prices, per unit costs, volume or efficiency has an impact on the profit margin or turnover ratios. Similarly any decision affecting the amount and ratio of debt or equity used will affect the financial structure and the overall cost of capital of a company. Therefore, these financial concepts are very important to evaluate as every business is competing for limited capital resources. Understanding the interrelationships among the various ratios such as turnover ratios, leverage, and profitability ratios helps companies to put their money areas where the risk adjusted return is the maximum
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