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The ROE ratio can be decomposed to provide a more specific source of a firm's superior or inferior performance. Remember that ROE equals Net Income divided by Shareholders’ Equity. We can rewrite the formula as

where T = firm's tax rate.

By doing the math, this formula condenses to the ROE formula above. You may also notice that we have already seen some of these ratios (profit margin, total asset turnover). The purpose of the formula is to see what is actually driving ROE based on other performance measurements. While some of these drivers are desirable as sources of ROE, others are a source of risk, being unsustainable sources of shareholder value creation.

The first term on the right-hand side of the equation is the profit margin ratio discussed previously, although here we use pretax income. A higher profit margin ratio means that the firm is converting more of its sales to net income available to equity shareholders. Ideally, a firm would like to increase this ratio to improve ROE. The second term is the total asset turnover ratio discussed in the management efficiency section. We previously indicated that a higher ratio indicates that management is efficiently using its assets to generate sales. A firm that is able to generate a higher ROE than its competitors because of its asset turnover has a competitive advantage in efficiency.

The third term in the equation is another way of expressing financial leverage. While financial leverage is discussed more in depth in Chapter 11, it is necessary to point out here that a higher ratio is not necessarily better and can in fact introduce more risk into the firm. Recall from Chapter 3 the basic accounting equation: Assets = Debt + Equity. If assets are financed by either debt or equity, then a higher financial leverage ratio means that the firm is using more debt to finance its assets (a larger numerator and a smaller denominator). While having some debt in the firm's capital structure is encouraged due to the tax deductibility of interest, at least in the United States, having too much debt can put the firm in a financial bind and can lead to insolvency. An ROE that is driven largely by financial leverage, therefore, is not sustainable and can indicate that managers provide a return to equity holders only by introducing more financial risk into the firm.

The last component of the formula above, 1 – T, specifies how much of the firm's ROE is due to its tax rate. A lower tax rate will increase the value of this multiplier and hence increase ROE. While it is in the best interest of the firm to have the lowest tax expense possible, increases in ROE due solely to a lower tax rate are not sustainable and could indicate that management is trying to manipulate ROE. All else being equal, a firm that is able to generate a higher ROE due to increased profit margin and/or increased total assets turnover is preferable to one that relies on financial leverage and an abnormally low tax rate.