Join Jim Stice for an in-depth discussion in this video DuPont framework, part of Running a Profitable Business: Understanding Financial Ratios.
- Okay, as we saw, Uncertain had a return on equity of 9.3%. Not good. Benchmark had a return on equity of 20.3%. Very good. Now, anybody can see that Benchmark is higher than Uncertain when it comes to return on equity. Turns out, we can now be either a problem pointer or a problem solver. Anybody can see that Uncertain has a problem. What we want to know now is why do they have a problem. And that brings us, in all its glory, to the DuPont Framework.
Now the DuPont Framework has these three components, Profitability, Efficiency, and Leverage. When it comes to Leverage, that's an indication of how much money have we borrowed to purchase assets, and why do we purchase assets? We purchase assets in hopes of generating sales. The Leverage measure tells us how many assets we've been able to acquire with the equity that's been put in the company. We've borrowed to buy. It gives us a measure of how much we've borrowed to buy assets. And why do we buy assets? To generate sales.
That's what the Efficiency ratio is measuring. We buy assets to generate sales. The more sales we can generate per dollar of assets, the better. And why do we want sales? That leads us to our Profitability measure. The more sales we have, the higher our income's gonna be. So first of all, we borrow money to buy assets. We buy assets to generate sales. We generate sales to generate net income. Our return on equity measure tells us how much income did we generate given a fixed amount of stockholder's equity that's been invested by the owners in the firm.
Now with that framework, let's take a look at Uncertain versus Benchmark, and use the DuPont Framework to identify, not only, how Uncertain has done, but why have they performed, particularly relative to Benchmark. So we can see the two companies' return on equity and DuPont Framework ratios here. Uncertain with 9.3%, Benchmark with 20.3%. Then we can see the Profitability measures for Uncertain and Benchmark, the Efficiency measures for Uncertain and Benchmark, and the Leverage measures for Uncertain and Benchmark.
To review, we looked at Leverage, Efficiency, and Profitability for Uncertain and Benchmark, and the first thing we noticed was that Leverage wasn't an issue. Leverage was the same for both companies, so in explaining the difference in return on equity between Uncertain and Benchmark, it can't be attributed to Leverage. So then we looked at Efficiency, and it turns out we found out that Uncertain generates $1.38 in sales for each dollar's worth of assets it has, compared to Benchmark, which generates $1.70 in sales for every dollar's worth of assets that they have.
Benchmark is much more efficient at generating sales with its assets than is Uncertainty. Then we looked at Profitability. When it came to Profitability, Uncertain was generating $3.5 in profit for every $100 in sales, compared to Benchmark, which was generating $6.2 in profit for every $100's worth of sales. So why was Benchmark's return on equity so much higher than Uncertain's? Profitability and Efficiency.
Benchmark is much better at generating sales with its assets and generating earnings with the sales that it has. So, now do we have any other questions? Well, when it comes to Efficiency, which specific assets are being used inefficiently by Uncertain? Which expenses are too high, which would account for their lower profitability? We want to know the answer to those questions, and we will do further analysis to get there.
- What are financial statements?
- Understanding the DuPont framework
- Working with common-size financial statements
- Reviewing profitability, efficiency, and leverage ratios
- Analyzing potential-pitfall ratio