Everything You Need To Know About Return Ratios And DuPont Analysis

The rates of return represent a company's ability to generate returns for its shareholders. The return on equity (ROE) and the return on capital invested (ROCI) are indexes used to measure the efficiency with which a company can generate profits. The return on capital employed measures the efficiency with which a company can use its capital - both debt and equity. A high ROCI shows evidence of efficient use of capital. Here this article explains how ROE and ROCI are calculated and why these are the most important parameters in understanding a business. This article further talks about Returns On Assets (ROA) and the DuPont Analysis which are the complementary parts of this topic.

The Return On Assets: the earning from the investment

Return on assets (ROA) is an indicator of how profitable a company is in relation to total assets. ROA gives a manager, investor or analyst an idea of??how efficient a company's management is in using its assets to generate earnings. The return on assets is displayed as a percentage.

So now we know that we can calculate ROA as

Return on Assets = Net Income / Total Assets

Companies (at least those that survive) are essentially about efficiency: making the most of limited resources. Comparing profits with revenue is a useful operational metric, but comparing them with the resources a company used to obtain those cuts the very viability of the company's existence. Return on assets (ROA) is the simplest of these corporate measures.

Now let’s talk about its DuPont Analysis

The return on assets (ROA) ratio developed by DuPont for its own use is now used by many firms to evaluate how effectively assets are used. It measures the combined effects of profit margins and asset turnover.

ROA= NET INCOME / REVENUE * REVENUE / TOTAL NET ASSETS = NET INCOME / TOTAL NET ASSETS

The return on equity is determined as the amount of profit a company derives from the shareholder's investment in the company or is a measure of how effectively a company invested in the dollar amount and made a better profit out of it. The return on equity is more important than the return on investment for shareholders, as it defines how their money is reinvested in a company. The return on assets determines how much profit a company makes for every dollar of its assets. The asset can be anything like money in the bank, accounts receivable, property, equipment, inventory and furniture. The return on assets defines the gains that a company is generating from the invested capital (assets). The return on assets varies substantially for public companies that depend heavily on the sector.

Return On Equity: the basis of production

The return on equity (ROE) is a calculation of financial performance calculated by dividing net income by equity. Since equity is equal to a company's assets minus its debt, ROE is considered to be the return on net assets. ROE is considered a calculation of how effectively management is using a company's assets to generate profits.

So now we can say that we can calculate ROE as

Return on Equity = Net Income / Average Shareholders’ Equity

ROE is expressed as a percentage and can be calculated for any company if net income and equity are both positive numbers. Net income is calculated before dividends paid to ordinary shareholders and after dividends paid to preferred shareholders and interest to creditors as per the rules.

Now let’s talk about its DuPont Analisys

The return on equity (ROE) ratio is a measure of the rate of return to stockholders. Decomposing the ROE into various factors influencing company performance is often called the Du Pont system.

ROE= Net Income / Average Shareholders’ Equity = NET INCOME/ PRETAX INCOME * PRETAX INCOME/ EBIT * EBIT/ REVENUE * REVENUE/ AVERAGE TOTAL ASSETS * AVERAGE TOTAL ASSETS / AVERAGE TOTAL EQUITY

Where

Net Income = net income after taxes

Equity = shareholders' equity

EBIT = Earnings before interest and taxes

Pretax Income is often reported as Earnings before Taxes or EBT

OR simply

ROE = FINANCIAL LEVERAGE * ROA

Return on Capital Employed:

Return on capital employed (ROCE) is a financial index that measures a company's profitability and the efficiency with which its capital is used. In other words, the index measures how well a company is generating profits from its capital. The ROCE ratio is considered to be an important profitability ratio and is often used by investors when selecting suitable investment candidates.

So we can calculate?

ROCE= EBIT / Capital Employed

where:

EBIT=Earnings before interest and tax

Capital Employed=Total assets? Current liabilities.

For

S. Vishwa is web marketing analyst at Finology Ventures. With 5+ years of web marketing experience, joined a Fintech company to help people to learn and earn more.