On its own, a company’s return on equity (ROE) analysis is a rather simple and straightforward calculation. It simply involves taking the company’s net income and dividing it by the owner’s equity. Higher values imply the company is doing a good job of creating value for the company’s owners by increasing their rate of return. However, the standard ROE analysis doesn’t necessarily provide insight into which variables are contributing to higher or lower returns. To alleviate this as a going concern, the DuPont Corporation created a more in-depth calculation, one build around analyzing the returns of three essential criteria; profitability, operating efficiency and financial leverage.
The formula was created in the 1920s and lead to a new method of calculating ROE for enterprises. It’s become so popular that companies use the three criteria in order to determine multiple variables within their financial forecasts.
Simplifying the DuPont Analysis
The DuPont formula allows companies to assess multiple variables within their financial performance. They can use the analysis to come up with several “what if” scenarios and use these outcomes to determine their effects on the company’s ROE value. We’ll simplify how your company can use this analysis by defining each of those aforementioned criteria within a simple calculation. Afterwards, we’ll show how your company can break down the analysis into a labeled hierarchy chart, one where you can easily see all three levels of the formula and each individual calculation.
If one were to simplify the DuPont formula, it would simply include multiplying those three aforementioned criteria; the company’s profitability, its operating efficiency and its financial leverage. When thinking of leverage, think of the value of the company’s assets relative to its owner’s equity. The calculation within the financial leverage portion is called the equity multiplier. In this case, it is a ratio and one that defines how the company uses debt and capital to finance its assets. Because companies operate in different industries and markets, a company’s equity multiplier must be compared with similar enterprises. Comparing one industry to another won’t give a true indication of good or bad equity multiplier values. However, for the most part, a high value implies that a company is relying upon debt to finance its assets. Ultimately, a company must periodically compare its equity multiplier in order to gauge whether the value is moving in the right direction.
ROE = { [Profitability] x [Operating Efficiency] x [Financial Leverage] }
- Profitability: This portion of the analysis measures the company’s net profit margins. It includes taking the company’s net profit and divided it by the company’s sales.
Net Profit Margin: Net Profit ÷ Sales
- Operating Efficiency: This portion of the analysis measures a company’s asset turnover, which simply involves taking sales and dividing them by the company’s assets.
Asset Turnover: Sales ÷ Assets
- Financial Leverage: This portion of the analysis measures the company’s aforementioned equity multiplier, which is essentially the company’s assets divided by owner’s equity.
Equity Multiplier: Assets ÷ Equity
Using the DuPont ROE Formula in a Labeled Hierarchy Chart
The following chart shows the three levels of the formula. It’s important to note that the second level simply includes taking the company’s return on assets (ROA) value and multiplying it by the company’s financial leverage. In this case, both the net profit margin and asset turnover calculation form the basis of analyzing a company’s ROA.
When thinking of a company’s return on assets, think of how companies can increase revenues by better using their existing assets. These assets could include the company’s installed equipment base, its machines, its warehouse and most importantly, its inventory. For instance, a company may decide to lease existing, unused warehouse space to other enterprises, thereby increasing its revenue from its existing asset. Any situation where a company increases its sales, or revenue, by better utilizing its assets is an example of increasing the company’s ROA. While these aforementioned calculations can seem somewhat overwhelming, they are nothing more than a tool to analyze how a company is maximizing its returns. This leads us to the most important aspect of the formula; using the calculation to analyze financial forecasts.
How the Analysis Helps Financial Forecasts
The previous examples show how the formula helps enterprises answer several what if scenarios. For instance, what if your company better uses its existing assets? What if your company increases its prices, lowers it costs, increases its sales volumes, reduces its debt, lowers its financing costs, or lowers its cost of sales and or cost of goods sold (COGS)? Your company can play with each of these scenarios in order to see how each of them would impact your company’s ROE value.
Using the DuPont Formula
The best way to use the formula is to come up with a list of specific scenarios that are commonplace in your industry. These could include companywide objectives and goals, or could be as simple as analyzing what your company can do to emulate the success of competitors. First, start by coming up with a list of scenarios. Second, define those scenarios relative to their importance to your enterprise and its long-term goals. Third, try and come up with unique strategies that allow you to accomplish those you’ve deemed essential to your enterprise’s long-term future. The exercise will help your company come up with strategies to increase its ROE and provide greater insight into what contributes to your current value.
The DuPont formula is one that has been around in excess of 90 years. It is a proven strategy and one that allows companies to assess their current ROE and the impact of multiple variables on future values. Use the calculations to define your current return on equity. Next, come up with your own set of scenarios, ones that will help identify possible strategies to improving your company’s returns.
The above video is from the post: B2B Restocking Fees: Three Simple Steps to Covering Carrying Costs
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