3 step DuPont Return on Equity (ROE) analysis

DuPont Analysis of Return on Equity

1. Using the following table, calculate the Calculate the ROE in each year using the simple formula.

2. As an analyst using just this information, what do you conclude?

Select Financial Data for ABC Corp.
	2016	2017
Sales	2700	3300
Earnings After Tax	400	400
Total Assets	3500	4800
Total Equity	1600	1600

1. ROE 2016 = (Earnings After Tax) / (Total Equity) = 400/1600 = 25%

ROE 2017 = 400/1600 = 25%

2. ROE did not change year-over-year.

Can we go any deeper?

Breaking down ROE, a single ratio that measures profitability, into 3 ratios, one which measures profitability, one which measures how efficiently firms use their assets to generate sales, and one that measures the use of leverage in a firm’s capital structure, can help the financial manager identify what caused ROE to change, or in this case, stay the same.

DuPont ROE = EAT/Equity = (EAT / Sales) * (Sales / Assets) * (Assets / Equity)

2016: 400/2700 * 2700/3500 *3500 / 1600 = .1481 * .7714 * 2.1875 = 25%

2017: 400/3300 * 3300/4800 * 4800/1600 = .1212 * .6875 * 3.0000 = 25%

While ROE stayed the same, the net profit margin (a measure of profitability) declined and total asset turnover (a measure of how well the firm is using its assets to generate sales) declined. ROE stayed the same because the firm used more financial leverage, which could be detrimental in the future if performance in other areas continues to decline (how will the firm be able to make the interest and principal payments on its increased debt if performance continues to deteriorate?).