The breakdown of ROE into component ratios to assess the impact of those ratios is generally referred to as the DuPont Model.
Traditional DuPont equation:
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:
A company's over- or underperformance on ROA is due to one or both of these causes, or "drivers."
The extended DuPont model takes the above three factors and incorporates the effect of taxes and interest based on the level of financial leverage. It takes the profit margin and backs up to see the effect of interest and taxes on the overall return to shareholders. Therefore the extended model starts with EBIT (Earnings Before Interest and Taxes) rather than net income.
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)
ROE=tax burden*interest burden*EBIT margin*asset turnover*leverage
| robbiecow: FAN it|
Financial 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?|