The author presents the Return on Equity (ROE) as one of our most impo

The author presents the Return on Equity (ROE) as one of our most important benchmarks because it measures the return to the owners of the firm. because stockholders own the firm, maximizing their returns is considered an important goal.

Use the DuPont method to de construct the ROE into three components and briefly discuss what information each provides to the total ROE value.

ANSWER

DuPont breaks down the ROE into three components. The first is Net Income /Sales, or the net profit margin. Concisely, this value tells us how effective the firm is at holding onto sales revenue. The numerator is the bottom line of the income statement and the denominator of the equation is the top or beginning value of the income statement. In between the income statement subtracts out the various expenses associated with generating the firm’s gross income. The higher this value, the greater the firm’s profitability and the greater its control over expenses.
The second item is the total asset turnover ratio equal to sales/total assets. An analyst could view this as the firm’s ability to generate income with the assets in place. This ratio speaks to the choices management has made regarding the types of products being sold and the assets purchased to generate those sales. Again, higher values here are desirable.
The final DuPont component is the leverage ratio equal to total assets/common equity. This may be viewed as management’s ability to use other people’s money. For instance, a leverage ratio of 1.50 implies that for every $1.50 in assets for the firm, only $1 was funded by shareholders. The balance was funded by creditors of one type or another. An increase in this value will increase the return in shareholders, but it also increases their risk as it implies some formed of fixed financial obligations that must be met before any money is available for the stockholders.