FIN101 #10 THE MOST IMPORTANT RATIO

Sep 18, 2021 FINANCE 101

Which of those many ratios is the most important for managers to focus on?

This question is controversial, but many ­financial analysts focus on return on equity (ROE), since that number measures the returns to owners, who are arguably the ultimate bosses within a company. Because ROE is a widely used measure, it’s important to understand the factors that contribute to an ROE. The DuPont framework, a method of analyzing a company’s ­financial health originated by the DuPont Corporation in the early part of the twentieth century, provides a useful way to understand the levers of ROE.

The DuPont framework breaks ROE algebraically into three ingredients: pro­fitability, productivity, and leverage.

Profitability: The fi­rst important contributor to ROE is how profi­table a company is. That goes back to the notion of pro­fit margin. For every dollar of revenue, how much does it earn in net profi­t?

Productivity: Being profi­table is important, but an ROE can be bolstered by productivity as well. To measure a company’s productivity, we use the asset turnover ratio, which measures how effi­ciently a company can use its assets to generate sales.

Leverage: As we saw, leverage can magnify returns. It is also an important contributor to ROE. In this setting, we can measure leverage by dividing a company’s assets by its shareholders’ equity.

Like all other measurements, ROE is imperfect, two problems stand out. First, because it includes the effects of leverage, it does not purely measure operational performance. That’s why some people prefer a return on capital, which compares EBIT to a ­rm’s capitalization (debt plus equity). Second, it does not correspond to the cash-generating capability of a business.

By thanhnambui

I am a bank employee specializing in trade finance- a field that is not directly linked to my university major in Financial Investment. However, with a passion for economics and finance, I determined to pursue a higher education degree and successfully achieved a Master in Economics of Banking and Finance from CFVG in 2019. During that study time, I encountered many difficulties in consolidating background knowledge studied at university, which made me realize the necessity of building foundation for effective learning outcomes. Therefore, my friend and I decided to create Econfin-Invest to record basic knowledge of economics, banking, finance, and investment fields. The articles I write are carefully selected and collected from a wide range of different reliable sources such as textbooks, economic and financial reports and relevant journals. Most importantly, these articles are not A to Z lectures of subjects related to the aforementioned fields, yet simply articles I consider to be accessible to all interested readers as well as being essential to apply in everyday practices. Thank you for reading and supporting!

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