DuPont Analysis - ROA and ROE Ratio

ROA and ROE Ratio

The return on assets (ROA) ratio developed by DuPont for its own use is now used by many firms to evaluate how effectively assets are used. It measures the combined effects of profit margins and asset turnover.

The return on equity (ROE) ratio is a measure of the rate of return to stockholders. Decomposing the ROE into various factors influencing company performance is often called the Du Pont system.

Failed to parse (Missing texvc executable; please see math/README to configure.): \text{ROE} = \frac{\text{Net income}}{\text{Equity}} = \frac{\text{Net income}}{\text{Pretax income}} \times \frac{\text{Pretax income}}{\text{EBIT}} \times \frac{\text{EBIT}}{\text{Sales}} \times \frac{\text{Sales}}{\text{Assets}} \times \frac{\text{Assets}}{\text{Equity}}

Where

• Net income = net income after taxes
• Equity = shareholders' equity
• EBIT = Earnings before interest and taxes

This decomposition presents various ratios used in fundamental analysis.

• The company's tax burden is (Net income ÷ Pretax profit). This is the proportion of the company's profits retained after paying income taxes.
• The company's interest burden is (Pretax income ÷ EBIT). This will be 1.00 for a firm with no debt or financial leverage.
• The company's operating income margin or return on sales (ROS) is (EBIT ÷ Sales). This is the operating income per dollar of sales.
• The company's asset turnover (ATO) is (Sales ÷ Assets).
• The company's leverage ratio is (Assets ÷ Equity), which is equal to the firm's debt to equity ratio + 1. This is a measure of financial leverage.
• The company's return on assets (ROA) is (Return on sales x Asset turnover).
• The company's compound leverage factor is (Interest burden x Leverage).

ROE can also be stated as:

ROE = Tax burden x Interest burden x Margin x Turnover x Leverage

ROE = Tax burden x ROA x Compound leverage factor

Profit margin is (Net income ÷ Sales), so the ROE equation can be restated:

Failed to parse (Missing texvc executable; please see math/README to configure.): \text{ROE} = \frac{\text{Net income}}{\text{Sales}} \times \frac{\text{Sales}}{\text{Assets}} \times \frac{\text{Assets}}{\text{Equity}}