Saturday, 10 September 2011

Return on Equity

Return on Equity (RoE) = Net Income (NI) / Equity
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:

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 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?
It can quickly tell you the status of the leverage, 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.

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