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.