The DuPont Identity is a financial tool that can be used to see how three main factors affect ROE:
Profit Margin - Net Profit/Sales
Asset Turnover - Sales/Assets
Leverage Ratio - Assets/Equity
Suppose XYZ Corp. has a profit margin of 20%, asset turnover of 300%, and a leverage ratio of 50%. What would their return on equity be?
We can see that this relatively simple calculation is:
The DuPont Identity allows us to see that ROE is a complex measure. A company with a low profit margin may have a strong ROE if it is not levered up very much. The equation can be rearranged to solve for missing values, as in the following example:
Suppose ABC Corp. has a 10% profit margin, an ROE of 30%, sales of $2000, and equity of $1000. What is the value of its assets?
By plugging in the values given, we can solve for assets = $500