In this video, learn how to identify the components of the DuPont framework. This is a framework for analyzing company performance.
- The DuPont Framework is a tool to decompose a company's return on equity into three dimensions, profitability, efficiency, and leverage. Return on equity, or ROE, is a measure of the amount of profit earned per dollar of owner investment. ROE is computed by dividing net income by equity. In 2018, Walmart's ROE was 9%. ROE for Target was 26%. This means that shareholders who invested $100 in Walmart earned profits of $9 in 2018. If those shareholders had invested the same $100 in Target, they would've earned $26. ROE is the fundamental measure of financial performance from the standpoint of the shareholders. How much did we earn for each $100 that we invested? So, at least in 2018, the Walmart shareholders didn't do as well as did the shareholders of Target. Why not? Well, a quick way to get some insight into this question is to use the DuPont Framework to decompose the ROE for both Walmart and Target to see where Walmart fell short. Now, the DuPont Framework is named after the DuPont Company, where this technique of analysis was invented. The idea behind the DuPont Framework is that return on equity, computed as net income divided by equity, can be mathematically decomposed into three ratios, profit margin, asset turnover, and assets to equity. The profit margin is the number of dollars in profit for every $100 in sales. This is a measure of a company's profitability. Asset turnover is the number of dollars in sales generated each year from each dollar of assets. This is a measure of a company's efficiencies in using its assets to generate sales. Assets-to-equity is the number of dollars of assets purchased for each dollar of owner investment in the company. The way to cause this ratio to be more than one is to augment owner investment funds with borrowed money. The assets-to-equity ratio is a measure of financial leverage. Let's use these 2018 numbers to compute the DuPont Framework's ratios for Walmart and Target. The DuPont Framework ratio calculations look like this. Let's use these DuPont Framework numbers to answer this question. Why was Walmart's return on equity in 2018 only 9%, when Target's was 26%? We find the biggest reason for the difference right there in the first DuPont Framework dimension, profitability. The profit margin, or return on sales numbers show that in 2018, $100 in Walmart sales resulted in net income of only $1.4, whereas the same $100 in Target sales resulted in net income of $3.9. In 2018 Target controlled its expenses better and so was able to squeeze more profit out of each sale. Well, what about efficiency? The asset turnover numbers show that actually Walmart was more efficient than Target at using its assets to generate sales in 2018. $1 of Walmart assets generated $2.35 in sales, whereas $1 of Target assets generated only $1.83 in sales. This DuPont Framework analysis indicates that the efficient use of assets is one of Walmart's strengths. Finally, let's look at the leverage measure, assets-to-equity. The leverage measure shows that Target has been more aggressive at using borrowed money to expand the size of its business. For every $1 invested by shareholders Target has be able to buy $3.65 in assets by combining that $1 of shareholder investment with $2.65 in borrowed money. Walmart has not been as aggressive at using leverage. More borrowed money means more assets with the same initial shareholder investment. More assets means more sales. More sales means more profit, all with the same initial shareholder investment. Now, of course increased financial leverage brings increased financial risk, but we'll save that discussion for a different module. Now the DuPont Framework analysis allows us to quickly see why Walmart's 2018 return on equity was so much lower than was Target's. The primary reason, Walmart's 2018 profitability was much lower than was Target's. This low Walmart profitability was partially offset by higher Walmart efficiency in using assets to generate sales. The DuPont Framework is a great tool to illuminate how profitability, efficiency, and leverage work together to determine a company's return on equity.
- Describe line items that appear on financial statements.
- Differentiate between the three types of financial statements.
- Interpret current accounting issues and trends.
- Calculate the market capitalization of a company.
- Identify the most important expense for a retail company.
- Explain the use of common size financial statements.