A Better Way to Gauge Profitability

Return-on-equity (ROE) is the correct profit metric to evaluate the performance of a business. However, the primary emphasis on financial ratio analysis must be on operating performance. The "advanced" version of the DuPont model remedies the original model's failure to cleanly separate the effects of operating and financing decisions. It introduces the concept of return on net operating assets (RNOA) as the core measure of operating performance and clearly separates the effects of leverage and operating decisions. The advanced model does not change the result of the ROE calculation. However, the elements underlying the ROE ratio are different and provide a clean separation of operating and financing decisions. RNOA is effectively insulated from financing decisions. Changing the amount of debt does not affect the operating assets or the profit before interest expense and, therefore, does not affect RNOA. It also permits straightforward computation of the impact on ROE of alternative financing decisions. Changes in the interest rate affect the spread, while changes in the amount of debt affect financial leverage in a transparent manner.