Return on investment (ROI) is considered to be one of the most important analytical tools for evaluating a firm’s profitability, this relating some measure of earnings to some measure of investment in the company.  The most commonly used ROI measures are:

  • Return on assets (ROA) – Indicates management’s performance in using all the firm’s assets to produce income:

Net Income/Average Total Assets
or
(Net Income + After-Tax Interest Cost)/Average Total Assets

  • Return on capital employed (ROCE) – Uses earnings before interest, taxes, depreciation and amortization (EBITBA) relative to total shareholders’ equity (capital employed), thus ignoring the firm’s financing policy and tax position:

EBITDA/Capital Employed

  • Return on equity (ROE) – Measures management’s success in maximizing the return to shareholders:

Net Income/Average Total Equity

  • Return on common equity (ROCE) – Reflects returns to the firm’s common shareholders and is calculated after deducting the returns paid to the creditors (interest) and the providers of senior equity capital (i.e., preferred shareholders):

(Net Income − Preferred Dividends)/Average Common Equity

The DuPont formula is a comprehensive measure of a firm’s return on equity (ROE) in terms of its profit margin times its asset turnover times its leverage:

(Net Income/Sales) x (Sales/Assets) x (Assets/Equity)
or
Profit Margin × Assets Turnover × Leverage

The firm’s profitability is measured by profit margin, asset turnover measures the efficiency with which it uses its assets and its financial leverage is measured by the equity multiplier (Assets/Equity).  It provides a thorough view of a company’s financial health and operating efficiency and helps in locating the parts of the business that are underperforming.  Variations of the Du Pont formula have been developed for different industries.

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