January 31, 2010

The following article originally appeared in the January 2010 issue of ABC-Amega's free client newsletter, "Credit-to-Cash Advisor".

Return on Equity Financial Expression

Efficient use of assets is important for the profitability and growth of any organization. One of the easiest ways to gauge whether a company is an asset creator or cash user is to look at the return on equity (ROE) ratio. ROE is a strong measure of how well management is creating value for shareholders.

In its simplest form, ROE is calculated:

If the result of this basic ROE ratio increases over time, it is generally considered a good sign. However, the ratio can also rise when the company takes on more debt, increasing leverage, but decreasing shareholder equity -- a risky situation.

To avoid the false positive that the simple ROE calculation can give, the DuPont Analysis, a more in-depth method of determining Return on Equity, was developed in the early 1900s.

Origin of DuPont Analysis
F. Donaldson Brown, a staff person in DuPont's Treasury department, developed the DuPont model of return on equity.

The DuPont Analysis provides a starting point for determining the strengths and weaknesses of a company. The model is built on three components, which cover the areas of profitability, operating efficiency and leverage (liquidity).

Components of the DuPont Analysis

1. Net Margin (Net Income/Sales). This ratio measures after tax profitability -- how much profit a company makes for every $1.00 it generates in revenue. Net Income and Sales figures can be found on the Income Statement. Generally, the higher the ratio, the better.

   It should be noted that, in order to generate more sales, management might reduce the net profit by reducing prices. Lowest-cost firms (like Wal-Mart) have used this strategy very effectively.

2. Asset Turnover (Sales/Total Assets). This ratio indicates the amount of sales generated for every dollar's worth of assets. This evaluates the firm's efficiency in using its assets. Typically, the higher, the better. However, this ratio tends to be inversely related to the net margin, i.e. the higher the net profit margin, the lower the asset turnover.

   The Sales number to calculate this ratio is found on the Income Statement. The Asset figures, however, come from the balance sheet. Income Statement items are measured over an interval of time, while Balance Sheet items are measured at a specific point in time. This difference can skew the result. Therefore, rather than using Total Assets, it's a good idea to use Average Assets to ensure a more meaningful ratio.

3. Leverage Factor (Average Assets/Average Shareholder Equity). This ratio determines the extent to which the company relies on debt financing. The higher the number, the more debt the company is carrying. Averages are used to control any potential bias that may be caused by end-of-the-year values.

The DuPont Formula -- 3 Step Return on Equity

Utilizing all three ratios, the DuPont Analysis provides deeper insight into the health of the organization versus the simple ROE calculation (annual earnings/ shareholder's equity).

For instance, if a company's return on equity increases because of an improved net profit margin (net income/sales) or due to increased asset turnover (sales/assets), this is a very positive sign. But, if the assets to equity result is the reason for the increase, the company could very well be over leveraged (too much debt), which puts the company in a more risky situation.

While the DuPont Analysis is a good starting point when analyzing the creditworthiness of an organization, the result is not meaningful unless compared to an industry benchmark. If such a benchmark is not available, you should at least do a trend analysis of the same company's return on equity over 3 or more years.

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We thank ABC-Amega Inc. for the above information, which was originally published in their client newsletter "Credit-to-Cash Advisor". ABC-Amega Inc. provides 1st and 3rd party commercial collection services since 1929, and collecting in more than 200 countries worldwide. For further information, contact info@abc-amega.com.

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