A system of analysis has been developed that focuses the attention on all three critical elements of the financial condition of a company: the operating management, management of assets and the capital structure. This analysis technique is called the “DuPont Formula”. The DuPont Formula shows the interrelationship between key financial ratios.
Return on equity (ROE) = net income / total equity
If we multiply ROE by sales, we get:
Return on equity = (net income / sales) * (sales / total equity)
ROE = net profit margin * return on equity
Uses of the DuPont Equation
By using the DuPont equation, an analyst can easily determine what processes the company does well and what processes can be improved. Furthermore, ROE represents the profitability of funds invested by the owners of the firm.
All firms should attempt to make ROE as high as possible over the long term. However, analysts should be aware that ROE can be high for the wrong reasons. For example, when ROE is high because the equity multiplier is high, this means that high returns are really coming from overuse of debt, which can spell trouble.
If two companies have the same ROE, but the first is well managed (high net-profit margin) and managed assets efficiently (high asset turnover) but has a low equity multiplier compared to the other company, then an investor is better off investing in the first company, because the capital structure can be changed easily (increase use of debt), but changing management is difficult.