DuPont Return on Equity Formula

Accounting software gives business owners access to a lot of financial information, however, understanding what the numbers mean and how they can be used is a different matter. Perhaps one of the most important numbers for any business owner is the return on equity (ROE) which can be calculated using the return on equity formula.

The return on equity is a financial ratio which measures the ability of a business to generate a return for its owners. It is calculated by dividing the net income by the owners equity.

Expanding the Return on Equity Formula

On its own the return on equity formula tells you very little about how the business managed to make the return. In order to do this a technique called DuPont analysis is applied to the return on equity formula, which basically involves separating out the various aspects of the business to show how they have an impact on the return on equity.

The basic return on equity formula can be expanded into five separate financial ratios as follows:

ROE = Net income / Equity
ROE = (Net income / Revenue) x (Revenue / Assets) x (Assets / Equity)
ROE = (Operating income / Revenue) x (Revenue / Assets) x (Assets / Equity) x (Income before tax / Operating income)  x (Net income / Income before tax)
ROE = Operating margin x Asset turnover x Equity multiplier x Financial cost ratio x Tax effect ratio 

Using the DuPont return on equity formula analysis, a business owner can see which elements of the business contribute to their total return by looking at each of the five ratios:

1. Operating margin – How efficiently sales are being used to generate profits
2. Asset turnover – How well assets are being used to generate revenue
3. Equity Multiplier – How much the business is using financial leverage
4. Financial cost ratio – How much the financial leverage is costing the business
5. Tax effect ratio – How the business is impacted by the taxation system.

The first two terms, operating margin and asset turnover represent the operational aspects of the business, how much profit can be obtained from revenue, how well assets are managed. The next two terms, financial cost ratio, and equity multiplier show how the return on equity is effected by the capital structure and finance costs of the business. And finally the tax effect ratio shows the impact of taxation on the return on equity.

Return On Equity Formula Example

Consider the following extracts from the financial statements of two businesses.

A straight forward calculation of return on equity using the net income / equity formula shows the following results:

Although we now know the return on equity, only the DuPont analysis can reveal where that return came from. Using the DuPont return on equity formula analysis and calculating each of the five ratios in turn we get the following results:

Business A

The return on equity for business A is given as follows:

ROE = 1.79% x 1.90 x 1.08 x 3.26 x 0.68 = 8.13% 

The DuPont return on equity formula analysis shows that the business has a very low operating margin of 1.79%, but that the return on equity for investors is improved by the asset turnover of 1.90 and the high equity multiplier of 3.26, indicating a high level of debt is being used. As expected the impact of taxation reduces the return to the owners. These figures were in fact taken from the accounts of Amazon.

Business B

The return on equity for business B is given by

ROE = 93.98% x 0.15 x 1.01 x 1.25 x 0.79 = 14.10% 

The analysis in this case reveals that the business has an extremely high operating margin, however the return for the owners is reduced by the low asset turnover ratio, indicating the requirement for high levels of investment in assets relative to the levels of revenue being produced. This is compensated to some extent by the equity multiplier of 1.25 but reduced once again by the effect of taxation. These numbers were obtained from the accounts of Google.

The DuPont return on equity formula analysis is an easy method to make sense of a large quantity of financial information in order to determine which aspects of a business are impacting on the level of return for the owner. The five ratios effectively represent expense control, asset management, debt levels, cost of debt, and taxation. By comparing the ratios with other businesses or by watching the trend in the ratios over time, it becomes possible to identify the weaknesses in the business allowing action to be taken to correct the situation.

Our financial projections template allows easy identification of the base information on assets, equity, revenue, operating income, income before tax, and net income in order that the DuPont return on equity formula analysis can be carried out.