The DuPont Equation ROE = PM * AT * EM Where: ROE = Return on equityROE represents the percentage return on dollars invested in the firm ROE is important ratio to investors
The DuPont Equation – Part 1 - PM ROE = PM * AT * EM PM = Profit margin PM = Net income/Total revenues PM represents the percentage return on total revenues The higher the PM, the better management is doing at controlling costs
The DuPont Equation – Part 2 - AT AT = Asset turnover AT = Total revenues/Total assets Expressed as a number, the AT tells you how many dollars in revenue is produced by each dollar invested in assets. A higher AT tells us that assets are being managed efficiently
The DuPont Equation – Part 3 - EM EM = Equity multiplier EM = Total assets/Total equity If rearranged, EM = 1+(Total liabilities/Total equity) EM is a financial leverage measure; the higher the EM, the more reliant the firm is on debt
The DuPont Equation Quick and relatively simple way to measure the financial health of a firm Profit margin tells you how effective management is at controlling costs Asset turnover tells you how efficiently the assets are being used Equity multiplier tells you how financially levered the firm is; that is, it tells you how dependent the firm is on raising capital with debt, rather than equity. While there are advantages to debt, too much debt can be problematic.