|Course 305: Quantifying Competitive Advantages|
|DuPont and ROE|
To use the DuPont equation to calculate a company's ROE, we have to add a step to the process to account for the amount of leverage (debt) a company employs. We can break down ROE using the DuPont equation as follows:
ROE = ROA x (Asset / Equity Ratio)
ROE = (Asset Turnover) x (Net Profit Margin) x (Asset / Equity Ratio)
ROE = (Sales / Average Assets) x (Net Profits / Sales) x (Average Assets / Average Equity)
(Net Profits) / (Average Equity)
Notice that in the ROE breakdown, both sales and average assets cancel each other out.
One can draw the same insights about operating efficiency (profit margins) and asset use efficiency (turnover) as with ROA, but this adds the element of leverage to the equation. Clearly, companies can use leverage (debt) in order to boost their ROEs.
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