Return on Equity = Return on Assets (RoA) x Financial Leverage (FLA)
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:
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 product margin, tax 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's terms:
- 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?
- Return on Assets - How much income are we making relative to all the capital we put it (including debt)?
- Total Asset Turnover - How [efficiently are we using our assets]?
- Net Profit Margin - For each unit of good or service we sell, after the costs, how much do we keep?
- Gross Profit Margin - Before we do accounting and pay tax, how much of each good or service do we keep for each sale?
- Tax burden - After accounting practices, what is the effect of our current tax rate?
- Non-operating items - Can we use depreciation and amortization to affect our tax burden?