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DuPont analysis explained - YouTube
Channel: The Finance Storyteller
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ROE: Return On Equity.
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ROA: Return On Assets.
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ROS: Return On Sales.
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This video takes you through the financial ratios
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of the ROE formula, the ROA formula,
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the ROS formula, asset turnover and leverage,
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and shows how they fit together.
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The very basics and the very essence
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of financial ratio analysis!
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The beauty of financial ratios is that they link together
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information from two of the
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three main financial statements:
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the income statement or profit and loss statement, and
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the balance sheet.
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This gives you a more holistic view
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of a company's performance
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than merely looking at one financial
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statement in isolation.
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ROE or Return On Equity is defined as
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Net Income divided by Equity.
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In other words, the net profit that a company
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has generated during a year, divided by the
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book value of the shareholder capital
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invested in the company.
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ROE is a measure of
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the rate of return to shareholders.
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For Return On Equity, at first sight you would say:
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the higher this ratio is, the better!
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The Return On Equity financial ratio
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becomes more meaningful
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when you dive into its drivers.
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What made the ROE go up or down versus prior year
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if you look at the same company?
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Why is the ROE for two companies
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in different industries,
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or even in the same industry,
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different?
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This is where financial analysts owe a big Thank You
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to the DuPont corporation, for coming up
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with the idea of breaking ROE
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into three distinct elements.
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Let me walk you through these elements
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(ROS, asset turnover and leverage) shortly.
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But first, a trivia question.
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In which period did the DuPont corporation
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start using the DuPont analysis?
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Was it the 1890s, the 1920s,
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the 1950s or 1980s?
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When you are logged in to YouTube
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and are watching this video from a computer, then
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please click the voting card
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on the top right to submit your vote.
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I will explain you first what the DuPont formula is,
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and then share the answer to the quiz
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question towards the end of the video.
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Here's the 3-part version of the DuPont analysis.
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Mathematically, this split makes little sense,
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as you are multiplying fraction bars where
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the denominator in one of the fractions is the numerator
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in another fraction, hence they
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will cancel each other out when multiplied.
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For financial analysis,
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the split into three pieces makes a lot of sense!
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The first element, ROS or Return On Sales,
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is Net Income divided by Sales, which is an
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indicator of the relative profitability
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or operating efficiency:
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how many cents of profit
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are generated for every dollar of sales?
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The higher the ROS, the better.
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The second element is Asset Turnover,
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calculated as Sales divided by Assets, a measure of
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asset use efficiency.
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Can we maximize the amount of sales we generate
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with the assets that we have?
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A solid control of working capital (accounts receivable,
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inventory, accounts payable) is
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key here to decrease the denominator of assets.
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What are the terms you negotiate with your customers?
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Are you getting your customers to pay on time?
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Is your manufacturing
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and supply chain operation efficient,
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so the amount of inventory or stock
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along the way is minimized?
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All of those help to minimize the denominator.
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The first two elements together,
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ROS multiplied by Asset Turnover,
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form ROA, Return On Assets.
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This ratio of ROA has many variations,
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some companies measure
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ROIC Return On Invested Capital,
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ROTC Return On Total Capital,
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ROCE Return On Capital Employed,
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or RONOA Return On Net Operating Assets.
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These are all variations on the same theme,
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you look at the returns (profit) generated
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during a period, and compare them
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to the capital invested in the company to
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generate those returns.
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ROA is an indicator of business success,
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influenced by two factors: ROS or margin performance,
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and asset turnover
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which you could call speed or velocity.
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The last element of the DuPont 3-part equation
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is leverage,
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Assets divided by Equity.
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Whether this should be high or low
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is a much-discussed question
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among business people, finance people
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and academics,
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and I don't think there is a definitive answer.
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On the one side, if you can borrow money
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(take on debt) at low interest rates and put this money
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to productive use, you could grow
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the company faster and generate higher returns.
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On the other side, if debt is very high
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compared to the equity in the company, you increase
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the risk profile and decrease your buffer
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against bankruptcy.
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We have seen plenty of examples of companies
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that were too highly leveraged going under
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in various financial crises over the years!
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Alright, that's the most commonly known 3-step version
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of the DuPont formula.
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Are you ready for some more excitement?
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You can expand the DuPont formula to 5 steps,
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if you want even more analytical insight into
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the drivers of where your ROE increase or decrease
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is coming from.
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The two elements on the right stay the same:
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asset turnover and leverage.
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However, ROS gets split into three elements:
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Net Income divided by Earnings Before Tax,
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which is called tax burden,
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Earnings Before Tax divided by EBIT,
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called interest burden,
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and EBIT divided by sales, which is EBIT%.
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In a lot of companies, improving the EBIT%
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and increasing the Asset Turnover,
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are important targets for the management team,
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whereas the other elements are for the finance, treasury
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and tax departments to manage.
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To close the loop on the DuPont formula,
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the answer to the trivia question is that this
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financial ratio analysis method
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came into use in the 1920s!
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It is still in ubiquitous use,
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and can help you to understand
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the drivers of performance
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for your company.
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So thank you very much to Donaldson Brown
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of the DuPont corporation!
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On the Finance Storyteller YouTube channel,
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you can find lots of well-researched videos
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explaining business, finance and accounting topics.
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