Contabilidad & Finanzas 3

Lesson 9_ROE and DuPont Analysis

Francesco V. Giarmoleo
A brief recap of the last episode
 A brief recap of the last episode
Let’s come back to the lemonade stand
A brief recap of the last episode
Now we know these these financial metrics can help us keep the
lemonade stand running smoothly:

Return on Sales (ROS): measures how much profit you’re making

from each euro of lemonade sold after covering operating expenses.
If your ROS is high, it means you’re efficiently turning sales into
profit, keeping a good portion of revenue as earnings.

Return on Assets (ROA): shows how efficiently you’re using the

resources you’ve invested in your stand—like the stand itself, your
equipment, and your inventory—to generate profit. If your ROA is
high, you’re making good use of your assets to earn income.

Return on Investment (ROI): tells you how much profit you’re

making relative to the total amount of money invested in your stand,
including both equity and borrowed funds. If your ROI is high, your
stand is generating strong returns on the capital invested.

Net ROI: shows how much profit you’re making beyond the original
amount of money invested in your lemonade stand. It considers
whether your total income not only covers the capital you put in but
also generates excess returns. If your Net ROI is positive, you’re
earning more than you invested.
 A brief recap of the last episode
Now we know these indicators can help us keep the lemonade
stand running smoothly:

Your lemonade stand is running efficiently. You’re selling

lemonade, managing costs, and making a profit. You’ve
calculated your Return on Sales (ROS), Return on Assets
(ROA), and Return on Investment (ROI) to see how efficiently
and effectively your business is operating. Everything seems to
be in order. But then you start to wonder: Are you really
maximizing the returns for the owners—yourself or any other
investors?

That’s where ROE (Return on Equity) comes in. It helps you understand how much of the
lemonade stand’s profits are being returned to the owners, relative to their investment.
 This lesson

● Return on Equity (ROE)

● DuPont Analysis
 This lesson

● Return on Equity (ROE)

● DuPont Analysis
 Return on Equity (ROE)

● Net Income is the company's net profit, the income remaining after all
expenses, including interest and taxes, have been deducted.
● Shareholders' Equity is the difference between total assets and total
liabilities, found on the balance sheet.

ROE shows how effectively a company uses the money invested by its
shareholders to generate profits.
 Return on Equity (ROE)

Company Net Income (€) Shareholders' Equity (€)

Company A 5,000,000 25,000,000
Company B 8,000,000 50,000,000

• ROE?
 Return on Equity (ROE)

•Company A has a higher ROE (20%) compared to Company B (16%), meaning Company A
is more efficient at converting shareholder equity into profit.

•Possible reasons for the difference:

•Profitability: Company A may have better profit margins or more efficient operations.
•Capital Structure: Company A may use less equity (or more leverage), boosting its ROE.
•Industry Factors: If they are in different industries, the difference may reflect varying norms.
 Return on Equity (ROE)

High ROE:

● A high ROE indicates that the company is generating a strong return on

shareholders’ investments. This is generally seen as a positive sign,
suggesting that management is efficiently utilizing equity capital to create
profits.
● Typically, a high ROE is in the range of 15% to 20% or higher, depending
on the industry.

Low ROE:

● A low ROE can indicate less efficient management of equity capital. It may
signal weak operational profitability or unproductive investments.
 Return on Equity (ROE)

High ROE:

•High efficiency in capital use (e.g., technology companies with low capital needs).
•Strong revenue streams with recurring income (e.g., software subscriptions, financial
services).
•Use of leverage in capital-intensive industries (e.g., real estate, financial services) to
amplify returns.

Low ROE:
•High capital requirements and significant fixed costs (e.g., manufacturing, retail).
•Intense competition that limits pricing power (e.g., retail, e-commerce).
•Low margins and commoditized products, which reduce profitability despite high sales
volume (e.g., grocery retail).
 Return on Equity (ROE)
Average
Sector ROE Characteristics
(Range)
Retail and e-commerce companies have moderate ROE due to slim
profit margins and significant capital investment in inventory and
Retail/E-commerce 10–15%
logistics. E-commerce can achieve slightly higher ROE with efficient
inventory management and lower fixed costs.
Real estate firms often have a stable but moderate ROE, driven by the
Real Estate 8–12% capital-intensive nature of property investments. Leverage is commonly
used, which can enhance ROE but increases risk.
Technology companies, especially those in software, tend to have high
ROE due to scalable products, recurring revenue streams, and low
Technology 15–30%
capital requirements. Hardware-focused firms may see lower ROE due
to higher production costs.
ROE in manufacturing varies by sub-sector. Efficient production
Manufacturing 8–15% processes and supply chain management can enhance returns, but
high capital investment requirements often keep ROE moderate.

Financial services firms, including banks and insurance companies,

usually report high ROE, driven by diversified income streams (e.g.,
Financial Services 15–25%
fees, interest) and leveraging financial assets. However, they are
sensitive to economic cycles.
 Return on Equity (ROE)

Is having a very high ROE

always good?

When a Very High ROE is Positive

● Efficient Capital Use:

○ A high ROE can indicate the company is generating substantial profits with minimal
shareholder equity, reflecting operational efficiency and strong profitability.
● Scalability:
○ High ROE may result from business models that scale revenue faster than costs,
leading to significant returns for shareholders.
● High Margins:
○ Companies with high pricing power or low costs (e.g., luxury goods or software)
naturally produce higher returns on equity.
 Return on Equity (ROE)
When a Very High ROE is Concerning

● High Leverage (Debt-Driven ROE):

○ ROE can be artificially inflated if the company uses significant debt instead of equity to
finance operations.
○ While this reduces the denominator (shareholders’ equity), it increases financial risk
and vulnerability to interest rate changes or economic downturns.
○ Example: A company with €100M in assets but only €10M in equity (and €90M in debt)
may show a high ROE but be at significant risk.

● Equity Reduction:
○ If the company engages in aggressive share buybacks, the equity base shrinks,
increasing ROE even if net income remains flat.
○ This can mask declining operational performance.

● Unsustainable Growth:
○ High ROE due to rapid growth may not be sustainable, especially if market conditions
change or competitive pressures increase.
○ Overemphasis on maximizing ROE can lead to underinvestment in long-term assets or
R&D, jeopardizing future profitability.
 Return on Equity (ROE)

Should a Very High ROE Be the Objective?

Not Always. Instead, ROE should:

● Be sustainable: Ensure the high ROE comes from operational efficiency and
profitability, not excessive debt or equity manipulation.
● Align with industry benchmarks: Compare the company’s ROE to sector
norms to determine if it reflects genuine outperformance.
● Balance risk and return: A moderately high ROE with a stable risk profile is
often better than a very high ROE driven by leverage.
● Target an ROE aligned with industry norms.
 Return on Equity (ROE)
So ROE alone can be deceitful…what to do? Use complementary metrics:

Metric Focus Key Question Answered

ROE (Return on Shareholder "How much profit does the company generate
Equity) profitability per unit of shareholder equity?"

ROS (Return on Operational "How efficiently does the company convert

Sales) profitability sales into profit?"

ROA (Return on "How well does the company use its assets to
Asset utilization
Assets) generate earnings?"
ROI (Return on Investment "How profitable are the company’s
Investment) profitability investments?"
Core operational "How much profit remains after direct
Gross Margin
efficiency production costs?"
"How profitable are the company’s core
Operational cash
EBITDA operations before accounting for financing and
flow capacity
taxes?"

"What percentage of revenue becomes net

Net Profit Margin Overall profitability
income after all expenses?"
 Return on Equity (ROE)
Scenario:
You are analyzing ABC Corp, a mid-sized manufacturing company. The company has been growing,
but management is unsure whether they are actually using their resources efficiently. They ask you
to evaluate their financial health using multiple return ratios.
You are provided with the following financial data for the past year:

Metric ABC Corp (€)

Net Income 7,000,000
Shareholders' Equity 35,000,000
Revenue 120,000,000
Total Assets 150,000,000
Investment Cost 15,000,000
COGS (Cost of Goods Sold) 80,000,000
EBITDA 14,000,000

1. Calculate Each Return Ratio.

2. Interpret the results and make suggestions.
Return on Equity (ROE)
 Return on Equity (ROE)
Interpreting the Results & The Surprise
🚨 At first glance, ABC Corp looks successful with a solid ROE of 20%, but
other metrics reveal underlying problems!
•High ROE but Low ROA: Profitability is strong for shareholders, but the
company isn't using its total assets efficiently.
•Low ROS and Net Profit Margin: ABC Corp has high sales but weak
profitability, meaning costs are eating into earnings.
•Strong ROI: The company makes good returns on investments, but this
hasn't yet translated into overall efficiency.

👉 Surprising Insight: ABC Corp might be growing TOO aggressively—it

has good investments and high ROE, but low profitability and asset efficiency
indicate possible inefficiencies, bloated assets, or high operational costs.
 Return on Equity (ROE)

How to Improve ABC Corp's Financial Health

✅ 1. Improve Cost Efficiency (Gross Margin, EBITDA, Net Profit Margin)

• Optimize supply chain to reduce material costs.
• Negotiate better vendor contracts to lower expenses.
• Reduce waste in production to increase margins.
✅ 2. Better Asset Utilization (ROA)
• Sell underperforming assets to free up capital.
• Increase asset turnover by boosting sales with the existing infrastructure.
✅ 3. Enhance Operational Efficiency (ROS, EBITDA Margin)
• Streamline operations to reduce overhead costs.
• Automate processes to improve productivity.
 Return on Equity (ROE)
To sum up:

High ROE + High ROS + High ROA + High ROI: Indicates a highly efficient, well-run
company that generates strong profits from sales, uses assets effectively, and makes sound
investment decisions.

Warning Signs in Metrics

● High ROE but low Gross Margin or EBITDA.

○ Possible Issue: Profitability could be driven by financial engineering (e.g., high
leverage) rather than strong operations.
● Low Net Profit Margin but high Gross Margin.
○ Possible Issue: Inefficiencies in financing, taxes, or non-operational expenses.

• High ROE + Low ROS or ROA: Suggests the company relies heavily on financial
leverage or equity management rather than strong operations or asset efficiency.

• High ROI but Low ROE or ROA: Indicates good project-level decisions but poor overall
profitability or resource utilization.
 Return on Equity (ROE)

So ROE alone can be misleading.

• One approach to gaining a clearer picture is to examine other
profitability ratios to understand the underlying factors.
• Another powerful method is DuPont Analysis.
 This lesson

● Return on Equity (ROE)

● DuPont Analysis
 DuPont Analysis

•Net Profit Margin (Profitability) → Measures how much of revenue turns into profit.

•Asset Turnover (Efficiency) → Measures how effectively the company uses its assets
to generate sales.

•Equity Multiplier (Leverage) → Shows how much debt the company is using to amplify
returns.
 DuPont Analysis

A high ROE could be coming from:

•Strong profitability (high Net Profit Margin)
•Efficient operations (high Asset Turnover)
•Excessive debt usage (high Equity Multiplier → Risky!)

📌 By breaking down ROE, DuPont helps identify which of these factors

is the real driver.

DuPont Analysis breaks ROE down into its key components, revealing what truly
drives a company’s profitability.

(The method was developed by the DuPont Corporation in the 1920s and is widely
used for financial analysis!)
 DuPont Analysis

We are given:

Company A (Strong Company B (High

Metric
Operations) Leverage)
Net Profit Margin 10% 5%
Asset Turnover 1.2 0.8
Equity Multiplier 1.67 5.0
ROE (to verify) 20% 20%

• Apply the DuPont Formula

DuPont Analysis
 DuPont Analysis
Both companies have the same ROE (20%), but their financial structures are very
different:
1.Company A has a higher Net Profit Margin (10%) and higher Asset Turnover
(1.2), meaning it generates strong profits and efficiently uses its assets.
2.Company B has a lower Net Profit Margin (5%) and lower Asset Turnover (0.8),
but its ROE is boosted by a high Equity Multiplier (5.0), meaning it relies heavily on
debt to amplify returns.

Without DuPont Analysis, we would only see ROE = 20% for both companies and
assume they are equally strong.
🔹 Company A is financially healthier because it generates profits efficiently without
excessive debt.
🔹 Company B is riskier because its ROE depends heavily on financial leverage. If
the company struggles to repay its debt, its returns could collapse.
 This lesson

● Return on Equity (ROE) measures how efficiently a company generates

profit from its shareholders' equity.

● DuPont Analysis measures the key drivers of ROE by breaking it down into
profitability (Net Profit Margin), efficiency (Asset Turnover), and financial
leverage (Equity Multiplier) to provide deeper insights into a company's
financial performance.
Profitability
 Profitability

Lesson 1: Introduction to Profitability

● Focus: Fundamental understanding of profitability metrics and their

implications.
● Key Indicators:
○ Gross Margin: Highlights the efficiency of production and sales
processes by showing how much profit remains after covering the cost
of goods sold.
○ EBITDA: Provides a measure of operational cash-generating capacity,
excluding the impact of financing and non-operational expenses.
○ Net Profit Margin: Shows the percentage of revenue converted into
profit, reflecting the overall efficiency of operations.
 Profitability

Lesson 2: ROS, ROA, and ROI

● Focus: Understanding returns across different dimensions of business

operations.
● Key Indicators:
○ ROS (Return on Sales): Evaluates operational efficiency by measuring
profit generated per unit of sales.
○ ROA (Return on Assets): Assesses the efficiency of resource utilization
by examining how effectively a company uses its assets to generate
profit.
○ ROI (Return on Investment): Analyzes the profitability of specific
projects or investments, offering insights into the effectiveness of capital
allocation.
 Profitability

Lesson 3: ROE and DuPont Analysis

● Focus: Linking profitability to financial leverage and operational efficiency.

● Key Indicators:
○ ROE (Return on Equity): Measures how effectively a company
generates profits for shareholders, providing insight into the company’s
overall financial performance.
○ DuPont Analysis: Breaks down ROE
 Profitability
Three Key Points on Profitability Analysis

1. Profitability Reflects Efficiency and Cost Management

•Gross Margin & Net Profit Margin → Show how effectively a company controls
costs and converts revenue into profit.
•EBITDA → Measures operational efficiency by focusing on core earnings before
financial and non-operational expenses.

2. Returns on Investments and Resources Indicate Financial Health

•ROA (Return on Assets) & ROI (Return on Investment) → Assess how
efficiently a company utilizes assets and capital to generate returns.
•ROS (Return on Sales) → Evaluates how well a company turns revenue into
operating profit.

3. Financial Structure and Leverage Impact Shareholder Returns

•ROE (Return on Equity) → Measures profitability from a shareholder’s
perspective, revealing financial performance.
•DuPont Analysis (Net Profit Margin × Asset Turnover × Equity Multiplier) →
Breaks down ROE to distinguish between operational efficiency and financial
leverage.