ROE: Return On Equity.
ROA: Return On Assets.
ROS: Return On Sales.
This video takes you through the financial ratios
of the ROE formula, the ROA formula,
the ROS formula, asset turnover and leverage,
and shows how they fit together.
The very basics and the very essence
of financial ratio analysis!
The beauty of financial ratios is that they link together
information from two of the
three main financial statements:
the income statement or profit and loss statement, and
the balance sheet.
This gives you a more holistic view
of a company's performance
than merely looking at one financial
statement in isolation.
ROE or Return On Equity is defined as
Net Income divided by Equity.
In other words, the net profit that a company
has generated during a year, divided by the
book value of the shareholder capital
invested in the company.
ROE is a measure of
the rate of return to shareholders.
For Return On Equity, at first sight you would say:
the higher this ratio is, the better!
The Return On Equity financial ratio
becomes more meaningful
when you dive into its drivers.
What made the ROE go up or down versus prior year
if you look at the same company?
Why is the ROE for two companies
in different industries,
or even in the same industry,
different?
This is where financial analysts owe a big Thank You
to the DuPont corporation, for coming up
with the idea of breaking ROE
into three distinct elements.
Let me walk you through these elements
(ROS, asset turnover and leverage) shortly.
But first, a trivia question.
In which period did the DuPont corporation
start using the DuPont analysis?
Was it the 1890s, the 1920s,
the 1950s or 1980s?
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I will explain you first what the DuPont formula is,
and then share the answer to the quiz
question towards the end of the video.
Here's the 3-part version of the DuPont analysis.
Mathematically, this split makes little sense,
as you are multiplying fraction bars where
the denominator in one of the fractions is the numerator
in another fraction, hence they
will cancel each other out when multiplied.
For financial analysis,
the split into three pieces makes a lot of sense!
The first element, ROS or Return On Sales,
is Net Income divided by Sales, which is an
indicator of the relative profitability
or operating efficiency:
how many cents of profit
are generated for every dollar of sales?
The higher the ROS, the better.
The second element is Asset Turnover,
calculated as Sales divided by Assets, a measure of
asset use efficiency.
Can we maximize the amount of sales we generate
with the assets that we have?
A solid control of working capital (accounts receivable,
inventory, accounts payable) is
key here to decrease the denominator of assets.
What are the terms you negotiate with your customers?
Are you getting your customers to pay on time?
Is your manufacturing
and supply chain operation efficient,
so the amount of inventory or stock
along the way is minimized?
All of those help to minimize the denominator.
The first two elements together,
ROS multiplied by Asset Turnover,
form ROA, Return On Assets.
This ratio of ROA has many variations,
some companies measure
ROIC Return On Invested Capital,
ROTC Return On Total Capital,
ROCE Return On Capital Employed,
or RONOA Return On Net Operating Assets.
These are all variations on the same theme,
you look at the returns (profit) generated
during a period, and compare them
to the capital invested in the company to
generate those returns.
ROA is an indicator of business success,
influenced by two factors: ROS or margin performance,
and asset turnover
which you could call speed or velocity.
The last element of the DuPont 3-part equation
is leverage,
Assets divided by Equity.
Whether this should be high or low
is a much-discussed question
among business people, finance people
and academics,
and I don't think there is a definitive answer.
On the one side, if you can borrow money
(take on debt) at low interest rates and put this money
to productive use, you could grow
the company faster and generate higher returns.
On the other side, if debt is very high
compared to the equity in the company, you increase
the risk profile and decrease your buffer
against bankruptcy.
We have seen plenty of examples of companies
that were too highly leveraged going under
in various financial crises over the years!
Alright, that's the most commonly known 3-step version
of the DuPont formula.
Are you ready for some more excitement?
You can expand the DuPont formula to 5 steps,
if you want even more analytical insight into
the drivers of where your ROE increase or decrease
is coming from.
The two elements on the right stay the same:
asset turnover and leverage.
However, ROS gets split into three elements:
Net Income divided by Earnings Before Tax,
which is called tax burden,
Earnings Before Tax divided by EBIT,
called interest burden,
and EBIT divided by sales, which is EBIT%.
In a lot of companies, improving the EBIT%
and increasing the Asset Turnover,
are important targets for the management team,
whereas the other elements are for the finance, treasury
and tax departments to manage.
To close the loop on the DuPont formula,
the answer to the trivia question is that this
financial ratio analysis method
came into use in the 1920s!
It is still in ubiquitous use,
and can help you to understand
the drivers of performance
for your company.
So thank you very much to Donaldson Brown
of the DuPont corporation!
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