DuPont Ratio popularized by DuPont Corporation. The DuPont ratio tells us that ROE is affected by three things:
- Operating efficiency (measured by profit margin ratio);
- Asset use efficiency (measure by total asset turnover);
- Financial leverage (measured by equity multiplier).
To understand more about the DuPont ratio, we recall the definition of ROE:
ROE = Net Income / Equity
We could expressed ROE as a correlation between two ratios, ROE and Equity Multiplier:
ROE = ROA x Equity Multiplier
ROE = ROA x (1 + Debt-Equity Ratio)
We can also rearrange the ROE formula into:
For example of the correlation of those three ratios, we can levereged up by raising debt but it will raising interest expense too. The higher interest expense could lower the net profit margin. If you want to see about other commonly used financial ratios, you could visit my last post about financial statement analysis.