The breakdown of ROE into component ratios to assess the impact of those ratios is generally referred to as the

Traditional DuPont equation:

- ROE = net income / common equity
- ROE = (net income / net sales) x (net sales / common equity). Therefore, ROE = (net profit margin) x (equity turnover).
- ROE = (net income / net sales) x (net sales / total assets) x (total assets / common equity)

Each of these components impacts the overall return to shareholders. An increase in profit margin, asset turnover, or leverage can all increase the return. There is a downside as well. If a company loses money in any year, the asset turnover or financial leverage multiplies this loss effect.

This implies that to improve its return on equity, a company should become more:

- Profitable (increase net profit margin, e.g., pricing and expense control).
- Efficient (increase total asset turnover, e.g., efficiency of asset use).
- Leveraged (increase its financial leverage ratio).

A company's over- or underperformance on ROA is due to one or both of these causes, or "drivers."

The

- EAT = EBT (1 - t), where t is the company's average tax rate. Substituting EBT(1 - t) for EAT in the expanded ROE equation gives us ROE = (EBT / sales)(sales / assets)(assets / equity)(1 - t).
- EBT = EBIT - I, where I equals the company's total interest expense. Substituting (EBIT - I) into the ROE equation for EBT gives us ROE = [(EBIT / sales)(sales / assets) - (interest expense / assets)] (assets / equity) (1 - t).
- Restated in accounting terms:
**ROE = [(operating profit margin) x (total asset turnover) - (interest expense rate)] x (financial leverage multiplier) x (tax retention rate)**

High financial leverage does not always increase ROE; higher financial leverage will lead to a higher interest expense rate, which may offset the benefits of higher leverage.

This breakdown will help an analyst understand what happened to a company's ROE and why it happened.

DariSH: Could anyone explain, why would 'Interest expense/assets' be an 'interest expense rate'? |

Oksanata: I do not know what kind of extended formula is this...usually they give following one:ROE= (net income/EBT)*(EBT/EBIT)*(EBIT/Revenue)*(Revenue/avg.total assets)*(avg.total assets/avg.equity) OR ROE=tax burden*interest burden*EBIT margin*asset turnover*leverage |

robbiecow: FAN itFinancial Leverage x Asset TO x Net Prof Margin x Int Burden x Tax Burden |

CFAToad: ROE is total equity, not common equity. |

: How does increasing leverage improve ROE? |