How do companies increase ROE? Understanding these three key levers is important!

Financial Leverage can be utilized by borrowing money, provided the company’s profitability surpasses the cost of borrowed funds and debt repayment is manageable

Return on Equity (ROE) serves as a gauge of a company's efficiency in generating profits from the equity shareholders have invested in the business. ROEs above 15 per cent are generally deemed favorable.

Calculating ROE is straightforward: divide annual pretax profit by average shareholder’s equity, a task easily accomplished using the company’s financial statements. However, what strategies can be employed to bolster ROE? There are three primary levers, each capable of positively or negatively affecting a business's ROE:

1. Profit Margin Percentage

2. Asset Turnover

3. Financial Leverage

These levers are integral components of the DuPont Model, which dissects ROE into its underlying elements. Let's explore how enhancing any of these levers can uplift ROE.

While many companies concentrate on Profit Margin percentage, substantial ROE improvements can be achieved by optimizing each lever. Enhancing Asset Turnover involves improving inventory turnover, reducing accounts receivable days, or minimizing idle equipment and excess facilities. Financial Leverage can be utilized by borrowing money, provided the company’s profitability surpasses the cost of borrowed funds and debt repayment is manageable.

Comparing your ROE and each lever against industry benchmarks can pinpoint areas needing improvement. The DuPont Model, named after the DuPont Corporation that popularized it in the 1920s, simplifies ROE calculation:

ROE = [ Profit Margin %] * [Asset Turnover] * [Financial Leverage]

Let’s delve into each of the three underlying components of ROE through illustrative examples:

1. Profit Margin per cent is a simple yet crucial metric calculated by dividing Net Profits by Net Sales. It serves as a yardstick to gauge how effectively a company is converting its sales into profits. Comparing your profit margin per cent to industry benchmarks provides valuable insights into your company's performance relative to peers. A higher profit margin per cent indicates better profitability and can significantly contribute to boosting your Return on Equity (ROE). Given its importance, most companies routinely monitor and report this metric as it offers a clear indication of financial health and operational efficiency.
2. Asset Turnover is a key financial metric calculated by dividing a company's Annual Sales by its Average Total Assets. This ratio serves as a crucial indicator of efficiency in utilizing assets. In comparison to industry standards, a higher turnover signifies more effective asset utilization, ultimately enhancing Return on Equity (ROE). However, excessively high turnover rates can potentially impede sales growth. Conversely, low asset turnover suggests overinvestment in assets, potentially stemming from idle equipment, surplus facilities, slow-moving inventories, or aged accounts receivable. Thus, monitoring and optimizing asset turnover is vital for maintaining optimal operational efficiency and financial performance within a company.                                           
3. Financial Leverage is a measure of how much a company relies on borrowed money to run its operations. It's calculated by dividing a company's total debt by its total equity. Essentially, it shows how much of the company's assets are financed by loans. Using borrowed money to buy assets can boost profits, but it's risky. If things go south, like during an economic downturn, the company might struggle to pay back its debts. This is especially true for industries like construction and infrastructure, which heavily rely on physical assets.While higher leverage can increase profits, it also raises the chance of financial trouble if the company can't handle its debt payments. So, finding the right balance between borrowing and equity is crucial.To assess your company's leverage, compare it to others in your industry. And always weigh the risks before deciding to take on more debt to boost profits.

As an investor focused on Return on Equity (ROE), it's crucial to understand the three components of the DuPont model: profit margin, asset turnover, and financial leverage. Increasing any of these components will boost ROE, provided the other two remain steady.