How to Increase a Firm's Return on Equity

Return on equity is a measure of financial progress from an owner’s perspective. The value of owner’s equity increases when return on equity is positive, and it decreases when ROE values are negative. Owners benefit from higher ROE values, and managers should seek ways to increase ROE, because they have a fiduciary duty to investors. Fortunately, return on equity is influenced by three different factors management can control: asset turnover, financial leverage and profit margin. Each of these can be adjusted through strategies that, if successful, can boost shareholder returns.

DuPont analysis views return on equity as the product of three factors: profit margin, financial leverage and asset turnover. Increasing any one of these factors while holding the others constant would increase the product of their multiplication, return on equity. DuPont analysis points to these three controllable inputs as ways to optimize return on equity.

Your net income divided by your sales produces your profit margin. It is the fraction of revenues that end up as profit and add to the equity of a firm. Higher profit margins lead to higher equity returns, all else being equal.

Asset turnover is sales divided by the value of the company’s assets. It is a measure of how much sales volume the company is generating. Holding other factors constant, higher asset turnover leads to higher return-on-equity values. This does not hold true when variable costs exceed the sales price, however, since every additional sale loses money when profit margins are negative.

You calculate financial leverage by dividing the value of the company’s assets by the value of its equity. This ratio is how many times over the owner’s equity has been multiplied through borrowing and other forms of credit. Greater financial leverage deploys more assets and benefits the shareholders of a company when the assets of a company generate value that exceeds the cost of debt.

Increasing any of these variables can have negative consequences. Raising prices can increase profit margins, but higher prices may decrease units sold, leading to lower asset turnover. Conversely, promotional activity may increase asset turnover but typically lowers profit margin by increasing advertising expenses or by lowering prices. Increasing financial leverage can increase borrowing costs and create larger, difficult-to-meet payments. Management should carefully weigh the costs and benefits of these strategies.