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14. Financial Statement Analysis

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Ratios: DuPont Model for Return on Equity (ROE)

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Alright, now let's decompose our return on equity ratio. Using what's called the Dupont model. Let's check it out. So remember return on equity, we've talked about this before, it measures the income a company earns. So we're talking about net income that we're earning compared to the level of equity, right? The return on the equity. So return on equity roo it's a common profitability ratio shows how profitable the company is, right? And remember investors, they want to make as much money as possible, they want that R. O. E. To be high. They want a really good, really high R. O. E. So what we're gonna do here is we're gonna break up the R. O. E. Using three ratios, three different ratios that that together form our O. E. Okay, so we're gonna use three ratios that give us better information on how R. O. E. Is derived. Alright, so let's review real quick what we know about our, oh we remember that our, oh we we learned as net income in the numerator divided by average common equity. Right? Whenever we're talking about return on equity, we're talking about the common shareholders. All right, because that's usually the stock that you're going to buy on the market, it's going to be the common shareholders uh compared to the preferred shareholders, right? So we're focused on common equity here. So this is the formula we learned net income in the numerator, above average common equity in the denominator. So we're gonna break it down now into these three ratios. We're gonna use profit margin total asset turnover and then what's called the equity multiplier, which is also known as the leverage ratio, It has to do with the level of debt. Okay, so let's see how these three ratios help us understand the return on equity a little better. So underneath there, I have the the ratios written out as we we learned them before. Okay, So our profit margin, that's net income over net sales. Right? So what does that tell us? What is our profit margin? Tell us? Well, it tells us the amount of net income we get per dollar of sales, right? Remember sales is the top of the income statement. This is the money worth bringing in from customers. Then we have all of our expenses, cost a good sold operating expenses, other expenses, we run around and then we finally get to our net income, right? So for every dollar that we sell every dollar that we bring in as revenue, how much of it is left at the end of the day as net income, right? That's what the profit margin tells us. Now, the next one, total asset turnover? Well, this one's telling us, right for every house for every dollar of assets, right? Our denominator, how many dollars of sales we earn per dollar of assets. So we want this to be high to right, we want to be turning our assets into sales as much as we possibly can. Ok, So net sales divided by average total assets. That's our total asset turnover. And what you might remember, you might have learned that these two together, the profit margin times total asset turnover. Well, this is a return on assets, R R O A ratio. Return on assets. Okay, so the profit margin times total asset turnover is our return on assets. Remember that return on assets is net income divided by average total assets. And if you look at just these first two, uh these first two ratios, we've got net sales in the denominator in the first one. Net sales in the numerator in the second one. So if you remember from algebra, we can cancel those out, right. If it's in the numerator and the denominator, they cancel out and what's left? We've got net income in the numerator and average total assets in the denominator, that is our return on assets ratio. And that's why these two ratios together equal return on assets. But we take it a step further here in the Dupont model. We don't just think about that. We're talking about return on equity. So we take our return on assets and we use our equity multiplier to get to return on equity. So what is our equity multiplier? That's this last ratio right here, and that's our average total assets divided by our average common equity. Right? So this is gonna give us information about how lever the company is. Right? If we have a lot of average total assets, but just a little bit of common equity, well, that means that we've got a lot of liabilities, right? Remember that assets equal liabilities plus equity. So we're gonna have to finance our assets with either liabilities or equity. So, if we only have a little bit of equity, that means we have a lot of liabilities and that's that means we're highly levered were a riskier company, but we can make a lot more money too. Ok, So the more debt that we have, the riskier we are, but in general, that means we have the potential to make more money or lose more money. Okay, so this equity multiplier, it deals with the riskiness of the company, the leverage that they have, how much debt they have outstanding? That's what it tells us. This is called the leverage ratio. Also, by the way? So the equity multiplier is also the leverage ratio. And what it does is it takes that are away from the first two ratios and it magnifies it, right? Based on the level of equity. Okay, so that's what we've got going on here. And in the end, we're gonna multiply the three of them together, the profit margin times the total asset turnover, times the equity multiplier, that equals our return on equity. Okay, So why did we go through all this trouble? What does this mean to us? Well, what it tells us is there's three ways that the company can increase its return on equity first. It can increase its profit margin, right? If it if it focuses on increasing its profit margin, well it's increasing part of that multiple, right? We're multiplying three things together. If we increase one of them, well that's gonna be a bigger number. So guess what? The next way we can increase our R. O. E. Is by increasing total asset turnover. Right? So by increasing total asset turnover, Roo is gonna go up in the same way. And the third way. Now this one's kind of interesting is by increasing the amount of debt that the company uses by focusing more on using more liabilities and less equity. Well, like I said, this levers the company right now there's less equity. There's the net income that we get is shared by a smaller group of people. Right? When we compare the level of assets that we keep to the amount of equity. Well, in essence, we're able to make more money because we've taken on this debt, we can grow our business but we're riskier to, right, we've got these interest payments, we're gonna have to repay this debt. But um in the end it's another way to increase our return on equity by making the company, in essence riskier. Right? So it's a riskier company when we when we increase the level of debt. Cool. So that's those are the three ways we can increase our R. O. E. So this gives the company better information and better things they can focus on. Maybe they'll think, hey, we can focus on our profit margin and really try and cut down on our expenses to increase our return on equity or, or we can really drive sales for our level of assets and increase the total asset turnover. Or let's just take on more debt and increase the company that way, but will be riskier. But we can have higher returns on equity. And one last note here is that uh, we can obviously have a negative return on equity. Right? And that's only gonna occur when we have a net loss. That's generally the main reason here, Right? Because when you think about net return on equity, we can have a negative net income, right. If we have a negative net income, that's a net loss and we're gonna have a negative return on equity in that case. Cool. So one more thing before we move on to some practice problems is I want to show you why this ratio equals our return on equity above. So just like we did with return on assets when I showed you how that equals return on assets with the first two ratios. Well, if we look at all three ratios together, right, we have net sales in the denominator and net sales in the numerator for the 1st and 2nd ratio. So we could cross those out, right? Because the numerator and the denominator, they cancel out and look at the next to average total assets in the denominator and average total assets in the numerator, we can cancel those out. And what are we left with net income in the numerator? Average common equity in the denominator. And what did we learn above return on equity is equal to net income divided by average common equity. So that's why this ratio makes sense for the most part in this class, you're just gonna maybe have a problem where they give you these ratios. You have to multiply them together to get to return on equity just to show that you know how to use the Dupont model or you might have an analysis project where you're analyzing all sorts of ratios you have a company you're looking at and you're gonna use this information, this analysis. We just went through to give better information on the return on equity. Cool. So let's go ahead and do some practice problems the way you might see this on a on an exam. Alright, let's do that now.

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Problem

XYZ Company had a profit margin of 8.8%, total asset turnover of 0.77, and an equity multiplier of 1.8. What is XYZ’s Return on Equity using the DuPont Model?

A

12.2%

B

3.76%

C

20.57%

D

11.37%

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Problem

A company had a profit margin of 6.1%. The company’s net sales were $3,600,000 and Cost of Goods Sold was $600,000. If total assets were $3,450,000 at the beginning of the year and $4,210,000 at the end of the year, and total equity was $2,500,000 at the beginning of the year and $3,100,000 at the end of the year, what is the company’s return on equity using the DuPont model?

A

7.8%

B

8.8%

C

5.2%

D

Not enough information

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Problem

A company with net sales of $820,000 and net income of $210,000, average total assets of $1,400,000 and average common equity of $940,000 is using the DuPont Model for financial analysis. What is the company’s ROE?

A

22.3%

B

87.2%

C

15.0%

D

58.5%

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