According to the basic DuPont equation, a firms ROA is the product of what other two ratios
The DuPont EquationThe DuPont equation is an expression which breaks return on equity down into three parts: profit margin, asset turnover, and leverage. Show
Learning Objectives Explain why splitting the return on equity calculation into its component parts may be helpful to an analyst Key TakeawaysKey Points
Key Terms
The DuPont Equation DuPont Model: A flow chart representation of the DuPont Model. The DuPont equation is an expression which breaks return on equity down into three parts. The name comes from the DuPont Corporation, which created and implemented this formula into their business operations in the 1920s. This formula is known by many other names, including DuPont analysis, DuPont identity, the DuPont model, the DuPont method, or the strategic profit model. The DuPont Equation: In the DuPont equation, ROE is equal to profit margin multiplied by asset turnover multiplied by financial leverage. Under DuPont analysis, return on equity is equal to the profit margin multiplied by asset turnover multiplied by financial leverage. By splitting ROE (return on equity) into three parts, companies can more easily understand changes in their ROE over time. Components of the DuPont Equation: Profit MarginProfit margin is a measure of profitability. It is an indicator of a company's pricing strategies and how well the company controls costs. Profit margin is calculated by finding the net profit as a percentage of the total revenue. As one feature of the DuPont equation, if the profit margin of a company increases, every sale will bring more money to a company's bottom line, resulting in a higher overall return on equity. Components of the DuPont Equation: Asset TurnoverAsset turnover is a financial ratio that measures how efficiently a company uses its assets to generate sales revenue or sales income for the company. Companies with low profit margins tend to have high asset turnover, while those with high profit margins tend to have low asset turnover. Similar to profit margin, if asset turnover increases, a company will generate more sales per asset owned, once again resulting in a higher overall return on equity. Components of the DuPont Equation: Financial LeverageFinancial leverage refers to the amount of debt that a company utilizes to finance its operations, as compared with the amount of equity that the company utilizes. As was the case with asset turnover and profit margin, Increased financial leverage will also lead to an increase in return on equity. This is because the increased use of debt as financing will cause a company to have higher interest payments, which are tax deductible. Because dividend payments are not tax deductible, maintaining a high proportion of debt in a company's capital structure leads to a higher return on equity. The DuPont Equation in Relation to Industries The DuPont equation is less useful for some industries, that do not use certain concepts or for which the concepts are less meaningful. On the other hand, some
industries may rely on a single factor of the DuPont equation more than others. Thus, the equation allows analysts to determine which of the factors is dominant in relation to a company's return on equity. For example, certain types of high turnover industries, such as retail stores, may have very low profit margins on sales and relatively low financial leverage. In industries such as these, the measure of asset turnover is much more important. ROE and Potential LimitationsReturn on equity measures the rate of return on the ownership interest of a business and is irrelevant if earnings are not reinvested or distributed. Learning Objectives Calculate a company's return on equity Key TakeawaysKey Points
Key Terms
Return On EquityReturn on equity (ROE) measures the rate of return on the ownership interest or shareholders' equity of the common stock owners. It is a measure of a company's efficiency at generating profits using the shareholders' stake of equity in the business. In other words, return on equity is an indication of how well a company uses investment funds to generate earnings growth. It is also commonly used as a target for executive compensation, since ratios such as ROE tend to give management an incentive to perform better. Returns on equity between 15% and 20% are generally considered to be acceptable. The FormulaReturn on equity is equal to net income, after preferred stock dividends but before common stock dividends, divided by total shareholder equity and excluding preferred shares. Return On Equity: ROE is equal to after-tax net income divided by total shareholder equity. Expressed as a percentage, return on equity is best used to compare companies in the same industry. The decomposition of return on equity into its various factors presents various ratios useful to companies in fundamental analysis. ROE Broken Down: This is an expression of return on equity decomposed into its various factors. The practice of decomposing return on equity is sometimes referred to as the "DuPont System. " Earnings Per Share: EPS is equal to profit divided by the weighted average of common shares. The true benefit of a high return on equity comes from a company's earnings being
reinvested into the business or distributed as a dividend. In fact, return on equity is presumably irrelevant if earnings are not reinvested or distributed. Assessing Internal Growth and SustainabilitySustainable-- as opposed to internal-- growth gives a company a better idea of its growth rate while keeping in line with financial policy. Learning Objectives Calculate a company's internal growth and sustainability ratios Key TakeawaysKey Points
Key Terms
Internal Growth and Sustainability The true benefit of a
high return on equity arises when retained earnings are reinvested into the company's operations. Such reinvestment should, in turn, lead to a high rate of growth for the company. The internal growth rate is a formula for calculating maximum growth rate that a firm can achieve without resorting to external financing. It's essentially the growth that a firm can supply by reinvesting its earnings. This can be described as (retained earnings)/(total assets ), or conceptually as the total amount of
internal capital available compared to the current size of the organization. Optimal Growth RateAnother measure of growth, the optimal growth rate, assesses sustainable growth from a total shareholder return creation and profitability perspective, independent of a given financial strategy. The concept of optimal growth rate was originally studied by Martin Handschuh, Hannes Lösch, and Björn Heyden. Their study was based on assessments on the performance of more than 3,500 stock-listed companies with an initial revenue of greater than 250 million Euro globally, across industries, over a period of 12 years from 1997 to 2009. Revenue Growth and Profitability: ROA, ROS and ROE tend to rise with revenue growth to a certain extent. Due to the span of time included in the study, the authors considered their findings to be, for the most part, independent of specific economic cycles. The study found that return on assets, return on sales and return on equity do in fact rise with increasing revenue growth of between 10% to 25%, and then fall with further increasing revenue growth rates. Furthermore, the authors attributed this profitability increase to the following facts:
However, according to the study, growth rates beyond the "profitability maximum" rate could bring about circumstances that reduce overall profitability because of the efforts necessary to handle additional growth (i.e., integrating new staff, controlling quality, etc). Dividend Payments and Earnings RetentionThe dividend payout and retention ratios offer insight into how much of a firm's profit is distributed to shareholders versus retained. Learning Objectives Calculate a company's dividend payout and retention ratios Key TakeawaysKey Points
Key Terms
Dividend Payments and Earnings Retention Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. On the other hand, retained earnings refers to the portion of net income which is retained by the corporation rather than distributed to its owners as dividends. Similarly, if the corporation takes a loss, then that loss is retained
and called variously retained losses, accumulated losses or accumulated deficit. Retained earnings and losses are cumulative from year to year with losses offsetting earnings. Many corporations retain a portion of their earnings and pay the remainder as a dividend. Example Balance Sheet: Retained earnings can be found on the balance sheet, under the owners' (or shareholders') equity section. Stock dividends are those paid out in the form of additional stock shares of the issuing corporation or another corporation (such as its subsidiary corporation). They are usually issued in proportion to shares owned (for example, for every 100 shares of stock owned, a 5% stock dividend will yield five extra shares). If the payment involves the issue of new shares, it is similar to a stock split in that it increases the total number of shares while lowering the price of each share without changing the market capitalization, or total value, of the shares held. Dividend Payout and Retention Ratios Dividend payout ratio is the
fraction of net income a firm pays to its stockholders in dividends: Dividend Payout Ratio: The dividend payout ratio is equal to dividend payments divided by net income for the same period. Relationships between ROA, ROE, and GrowthReturn on assets is a component of return on equity, both of which can be used to calculate a company's rate of growth. Learning Objectives Discuss the different uses of the Return on Assets and Return on Assets ratios Key TakeawaysKey Points
Key Terms
Return On Assets Versus Return On EquityIn review, return on equity measures the rate of return on the ownership interest (shareholders' equity) of common stockholders. Therefore, it shows how well a company uses investment funds to generate earnings growth. Return on assets shows how profitable a company's assets are in generating revenue. Return on assets is equal to net income divided by total assets. Return On Assets: Return on assets is equal to net income divided by total assets. This percentage shows what the company can do with what it has (i.e., how many dollars of earnings they derive from each dollar of assets they control). This is in contrast to return on equity, which measures a firm's efficiency at generating profits from every unit of shareholders' equity. Return on assets is, however, a vital component of return on equity, being an indicator of how profitable a company is before leverage is considered. In other words, return on assets makes up two-thirds of the DuPont equation measuring return on equity. ROA, ROE, and GrowthIn terms of growth rates, we use the value known as return on assets to determine a company's internal growth rate. This is the maximum growth rate a firm can achieve without resorting to external financing. We use the value for return on equity, however, in determining a company's sustainable growth rate, which is the maximum growth rate a firm can achieve without issuing new equity or changing its debt-to-equity ratio. Capital Intensity and GrowthReturn on assets gives us an indication of the capital intensity of the company. "Capital intensity" is the term for the amount of fixed or real capital present in relation to other factors of production, especially labor. The underlying concept here is how much output can be procured from a given input (assets!). The formula for capital intensity is below: Capital Intensity=Total AssetsSales \text{Capital Intensity} = \frac{\text{Total Assets}}{\text{Sales}} The use of tools and machinery makes labor more effective, so rising capital intensity pushes up the productivity of labor. While companies that require large initial investments will generally have lower return on assets, it is possible that increased productivity will provide a higher growth rate for the company. Capital intensity
can be stated quantitatively as the ratio of the total money value of capital equipment to the total potential output. However, when we adjust capital intensity for real market situations, such as the discounting of future cash flows, we find that it is not independent of the distribution of income. In other words, changes in the retention or dividend payout ratios can lead to changes in measured capital intensity. Licenses and AttributionsCC licensed content, Shared previously
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Which two ratios are used in the DuPont system?Asset Turnover = Revenue ÷ Average Total Assets. Financial Leverage Ratio = Average Total Assets ÷ Average Shareholders' Equity.
How is DuPont ROA calculated?Calculating Return on Assets
In DuPont analysis, return on assets is a company's operating profit margin multiplied by asset turnover ratio. For example, a business with an operating profit margin of 22 percent and an asset turnover ratio of 2.4:1 has an ROA of 53 percent.
What is DuPont ROA?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.
How is DuPont ratio calculated?The Dupont analysis is an expanded return on equity formula, calculated by multiplying the net profit margin by the asset turnover by the equity multiplier.
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