Ratio Toolkit I: Profitability & DuPont

Learning objectives

By the end of the week you can:

1. Compute the four-layer margin stack (gross, EBITDA, operating (EBIT), and net margin) from either a US function-of-expense P&L or an Indian Schedule III nature-of-expense P&L, and name precisely which costs live between each pair of layers.
2. Explain what each margin layer isolates (product economics, the pre-capital-charge operating engine, full operating discipline, the all-in residual) and diagnose a business model from its margin signature alone.
3. Compute ROA and ROE with exact formulas and full convention discipline: average balances, parent-only numerator and denominator, preferred-dividend adjustment, and the ROA variants that neutralize financing.
4. Derive the 3-step DuPont identity algebraically (ROE = net margin × asset turnover × financial leverage) and decompose any company's ROE into its three levers.
5. Derive and run the 5-step DuPont (tax burden × interest burden × operating margin × asset turnover × leverage), and interpret each factor, including what a falling interest burden or an unusually high tax-burden factor is telling you.
6. Contrast a margin-led and a turnover-led route to the same ROE (Hindustan Unilever versus Walmart) and read strategy directly off the decomposition.
7. Use the leverage identity ROE = R + (R − i) × D/E to show exactly when debt inflates ROE, when it destroys it, and why two identical ROEs can carry very different risk.
8. State what profitability ratios cannot see (capital intensity, cash conversion, equity-base games, one-offs, cycle position) and name the module that supplies each missing lens.

Prerequisites & connections

Builds on. M1.02 (the multi-step income statement: the margin stack is that statement read as a ladder), M1.03 (the equity build, including non-controlling interest: ROE's denominator) and M1.05 (the three-statement linkage: you will pull D&A from the cash-flow statement when the P&L hides it). Then M1.07 (depreciation and amortization: the wedge between EBITDA and EBIT), M1.08 (leases: the EBITDA comparability trap returns here), M1.09 (NCI and SBC conventions) and M1.10 (filings navigation and non-GAAP policing: "adjusted EBITDA" games start in this week's territory).

Feeds forward. M2.02 gives the financial-leverage factor its full treatment (coverage, net debt, when leverage is survivable) and adds the velocity ratios that explain the turnover factor. M2.03 repairs the bluntest instruments here: total assets and total equity become NOPAT over invested capital, and ROIC replaces ROE as the master test of business quality. M2.04 asks whether the profits you measure here are backed by cash (CFO/NI). M2.05 disciplines every comparison you will be tempted to make this week (time-series, peers, common-size, segments). M2.06–2.08 weaponize the stack: a gross margin that rises while inventory balloons, or a net margin propped by "other income," are forensic tripwires. In Phase 3, margins and ROE drive the multiples (P/B is a function of ROE; EV/EBITDA inherits every EBITDA trap you learn here). In Phase 4, persistent margins and returns become the numerical proof of moats.

4.0 The question this module answers: and the one it defers

Every business is a machine that turns capital into sales and sales into profit. Profitability ratios measure the second conversion: of each rupee or dollar of revenue, how much survives each layer of cost? That is a question about return on sales. But Question 2 of the spine, is this a good business, is ultimately a question about return on capital: what does the machine earn on the money trapped inside it? You build both here, in their first, deliberately simple forms: margins for return on sales, ROA and ROE for return on capital, and DuPont as the bridge that shows how one becomes the other.

Hold one caution from the start. ROA and ROE use total assets and shareholders' equity straight off the balance sheet, honest but blunt measures that count idle cash, acquired goodwill, and every accounting accident of history. M2.03 sharpens them into ROIC. Learn the blunt tools first; you will use them within the first ten minutes of every teardown you ever run, precisely because they need no adjustments.

4.1 The margin stack: four tollgates between revenue and profit

Start with the intuition: ₹100 of revenue enters a toll road. At the first gate it pays for the product itself: materials, factory labor, freight. At the second gate it pays for the organization: salespeople, advertising, head office, R&D. At the third it pays for the machines wearing out. At the fourth it pays the lenders and the government. Whatever exits the road belongs to shareholders. The margin stack is simply the reading at each tollgate: