Inside ROE

ROE (return on equity) is one of the most important and common ratios used to analyse a company. And why not? We all want to see how much of the income is attributable to shareholders, who own the equity. However, just dividing net income by shareholders' equity can only tell you so much. In the 1920s, the DuPont Corporation developed a formula which broke ROE into three components: profit margin, asset turnover and financial leverage. This helps us understand the reason behind the increase or decrease in ROE. Here is the DuPont equation:

ROE = (Net income/Sales) x (Sales/Total assets) x (Total assets/Total equity)

The first part of the formula calculates profit margin. Profit margins usually increase if there is any increase in the selling price and/or decrease in expenses. An increase in the profit margin reflects a strong bargaining power. Asset turnover (the second part of the formula) tells us how efficiently a company is able to use its assets to generate revenue. A high asset turnover is usually the result of a company successfully increasing its sales and managing its assets in an optimal manner.

These two components examine the operations of a business. It is usually preferable that ROE increases due to any one or both of these factors (in case of the highlighted names, it increases because of both). However, it is worth noting here that net profit margin and asset turnover can be in contrast. For example, a company in the fast-food business may have a high asset turnover due to relatively lower assets but lower profit margins. Similarly, a manufacturer of customised and expensive equipment may have a low asset turnover but high profit margins.

The third part of the equation is financial leverage, which is also known as the equity multiplier. It tells us how much debt a company uses to fund its assets. Let's say a company has Rs 100 as assets and Rs 20 as owners' equity. The balance-sheet equation (assets less liability equals to equity) will signify Rs 80 as company debt. Hence, if a company borrows more to finance its assets, the ratio has to increase. This increases a company's risk of default and makes it riskier. However, the equity multiplier may increase due to reasons apart from an increase in debt.

We applied DuPont equation on the companies which have an ROE of more than 20 per cent. The tables list the results as per each segment.