Welcome to Excel and

Finance Video Number 19. Hey, if you want to download

the PDFs or our Excel file, click on the link

below the video and you download the chapter 3

for this finance class files, both PDF and Excel. Hey– oh, wow, we get to talk

about profitability ratios, profitability ratios. What is the return? Well, profit margin

we've already looked at. That we looked at when we did

common-sized income statements. It's simply net income

divided by sales. That means for every $1 of

sales, what is the net income? For every $1 of sales, how many

pennies of that is our profit? Now here's some points. Just simply– if you have

a high profit margin, a couple things

could be happening. One is maybe you're managing

expenses really well, especially in comparison to

some other business, right? Another possibility–

what if like Whole Foods, they have a kind of a premium

product, there's not very many other people that

specialize like they do an all-organic, all-natural

foods, so they can charge a little bit more, all right? So high profit margin

is probably pretty good, low profit margin is

probably not so good.

Oh, but wait a second. There are businesses

that totally have low profit margins. But maybe they have instead

of a high profit margin generating their profits,

maybe they have high volume. Actually, a lot of supermarkets

have very low profit margins but high turnover. Profit margin. Return on assets, sometimes

also said return on investment. But return on assets, I like

that one because it's just, hey, for every $1 of

asset, what's the profit? Also, return on equity,

very important ratio throughout this book

and throughout finance, return on equity is everywhere.

Now this is pretty

important– net income divided by total equity. So think about

this– $1 of equity, if we paid out all of the net

income to the stockholder, right? It would– this ratio would

give you how many pennies they get for every dollar

goes to the stockholder. Now think about this– even– our net income, we saw

this on the income statement.

Net income goes to two places. It's either paid

out as dividends or it's kept in the company. And the account that net

income is kept in is called retained earnings, and retained

earnings are plowed back into the company and

then you buy new assets. So this really

reflects everything the stockholder

is interested in, because dividends, well

that's cash to the equity holder, which is good,

but also, if they're plowing backlots of retained

earnings and buying new assets, presumably the

company is growing and the stock price will grow. So that's why return on equity

is such a common measure and a lot of people look at it. Now we want to talk about

this a little bit more– you can read some of

these notes if you want, but we want to talk about

this, because there's an amazing thing we can

do to return on equity.

It's called the DuPont analysis. Now in chapter 0.0, we've

talked a little bit about math and we talked

about the number 1. The number 1 is very important. And whoever– the people at

DuPont that thought this up, they knew about the number 1. So check this out. What's net income divided

by equity times 1 times 1? Well anything times

1 is still netting the same original

number, which in our case is net income divided by equity. But watch this– we're going

to choose the type of number 1 we want.

Anything by divided

by itself is 1. So sales times sales

divided by sales is the number 1;

times asset divided by asset, that's the number 1. Well guess what? When we set up this way– net

income over equity times sales over sales times

asset over assets, multiplication in the

denominator and the numerator can be done in any order, right? So right now we have E

for equity, S for sales, A for asset. But we could just as easily

put this A under the S right here– so it'd be SA. Or this S under the net

income and the E over here.

Well that's exactly

what we're going to do. We're going to take this

A, put it right here; the E, put it right here; and

the S and put it right here. Now what do we got? That looks like profit margin,

this looks like asset turnover, and this looks like

equity multiplier. Boom– three very

important ratios. This tells you the

operational efficiency, this one tells you how many

dollars of sales or revenue we get for every $1

of asset, and this tells us the equity multiplier

or looking at leverage, remember? This, anytime we

increase our debt, this is a number bigger than 1. So the more debt we have– so let's say we have half

debt and half equity, then this is the number 2, and

you can multiply it by these to increase it.

So by increasing debt– by breaking apart

return on equity and looking at any one

of these components, it can tell us what

it is that actually increased the return on equity. So if one year we saw 1.5

here, and the next year, return on equity went up really a

lot and you see 2.5 here, you could say, ah,

that's how they did it. They got a bunch of more debt. All right, but each

one of these tells us something important–

operation, efficiency of our assets generating sales,

and the amount of leverage. Now let's notice a

couple other things. Well, net income over

sales, notice there's– when we multiply these

together, it actually gives us a return on asset,

and technically the way you do it is, if you

have a number in the– the numerator and

the denominator, you can cross them out, right? And you're left with just

net income over assets, which is return on assets, right? So these two things

are return on assets.

So we can rewrite it

still another way– return on assets times

the equity multiplier. So sometimes you'll see it just

like this, sometimes you'll see broken apart– so

you have three component parts to help explain how

return on equity changed. Other times you see

it just like this. You just want to see the

return on assets and the equity multiplier. Still further, right? If we do this

little calculation, which we did in chapter 0.0, we

actually looked at this, right? Assets are really equity

plus debt divided by equity. Well break it apart– E over E is 1, that gives

us the 1; and D over E is the debt-to-equity ratio.

So a lot of times you'll

see it written this way. Return on equity? Hey, we got our return on assets

times 1 plus debt to equity. Now this seems all

unnecessary, really, but it really– they're

all different ways to write the same thing. And why do we have so

many different ways? Because this is a

very common number, people look at it all the

time, it's very important. So we can break it apart and see

slightly different perspectives with each one of these. Now I'm going to

go over to Excel, there's a little example

here you can look at. Actually, let's go

ahead and look at it. We have '98 numbers and '99. Well return on equity, 200

divided by 1,000 equity, right? 0.20. Oh, but wait a second. The next year, it's 200,

and equity went up, right? So it's 1,400. So make the division

and we get this number. So return– even

though the profits, the net income stay

the same, we issued a bunch more equity and return

on equity went down a lot.

That's called diluting

the equity, right? You buy– issue a lot

more stocks, right? And there's a lot more owners to

have to split up the earnings. All right, but

let's look at this. If we break this apart,

here's our profitability. Net income divided by sales. So 0.033. Here's our asset efficiency,

our sales divided by our assets.

$3 for every $1 of asset. And then our equity

multiplier, it's 2, right? 2,000 assets, 1,000 equity. So boom, boom, boom. Now looked at– when we do

the same numbers from '99, we can see why it went down

more explicitly, right? Here's the profit

margin in 1998. Profit margin actually

went up a little teeny bit. So that's not–

the profit margin isn't what caused the

return on equity to go down. Here, this one– 3– oh. So that one went down, we're not

being as efficient generating revenue from our assets. And finally, we issued a

bunch of equity, right? So our equity

multiplier went down. So it was efficient use of

assets and our use of leverage that caused our return

on equity to go down. Now let's go over to Excel. We're on the sheet that's

called Whole Food Markets International DuPont, and then

here's the answer over here. Let's just go ahead– before we do our

DuPont analysis, let's just do our straight

profit margin return on assets, return on equity.

Equals, and we're

doing it for 2006. So we're going to say net

income divided by sales. 3.6% or 0.036 as a decimal

or proportional rate. Equals net income divided

by our total assets. That's return on assets, OK? So 0.09. This one– oh,

let's do one more. This is the return on equity. So we're going to take

our net income divided by our total equity. OK, return on equity, 0.14. So what all– what

does this mean, right? For every $1 of sales we

brought in, $0.36 of that dollar went to profit. The rest was

consumed by expenses. For every $1 of asset,

we generated 9.9– about $0.10 worth of profit. This one says for

every $1 of equity, there was about $0.145 cents

of net income or profit. Now, let's break apart. I want to do profit margin,

asset turnover, and equity multiplier– three of them,

because that explains three components of

return on equity, and then want to

actually multiply and see that they are exactly

equal if you do it this way or straight our way right there.

So when we get over here, we

better get the same number. This we just did for 2006, but

we're going to do these numbers for '05 and '06. So net income

divided by our sales. And then equals, for 2006,

net income divided by sales. So 2.9% to 3.6%, or as

a decimal, that to that. All right, our asset turnover

equals our net income– this is 2005– divided by our assets. Oops, I did that wrong. Equal sales divided

by our assets. Equals all the sales for 2006

divided by our assets at the– ending number on

the balance sheet. So from '05 to '06,

we went up, right? We were a little bit more

efficient in generating dollars of sales from our

assets and equity. We're going to say

total assets– whoop– divided by our total equity. And then total assets

divided by our equity. So we're a little bit

more leveraged now, it went up a little bit. Now let's multiply these. All right, I'm going to use

the Product function, Product, and I'm going to multiply these. 1, 2, 3. Now we didn't do a

calculation for 2005, but let's just do it real quick.

That divided by total equity. I got my fingers crossed– yep, exactly the same. Now this is our relative

cell references, so we can copy it down

and ding, ding, ding, we get the same number

we calculated over here. So for now, we have

more information. We can look at each one

of these component parts and figure out why return

on equity went up or down. Now the product of these

two equals return on assets. So let's check that,

and in fact, I probably should have just gone

ahead and maybe I'll leave out that so when

you download the template, it will be just like this. Return on assets, if

I drag that over– so now we have the

return on assets was 7%, and then the profit

margin here was 2.9. OK, and– well let's come

down here and we're going to multiply, do the same thing– we could use the

product or we can just go like this times this. So that's profit margin

times asset turnover, and those are the two component

parts to return on assets, and sure enough, we

get the same thing. I'm going to go ahead

and drag it down.

So now it's multiplying

those, and sure enough, we get that exact number there. One final version of this is

do we know the debt to equity? We don't. We have our debt to equity. We didn't calculate

that anywhere, but we'll go ahead and do that. I'm just going to bring

these, because this is return on assets. So I'm going to

click here, equals, and get my return on assets– I don't need to

recalculate that– and then copy it down.

So that one's just

looking there. And now I'm going to

go equals 1 plus debt– and this is for 2005. So total debt divided

by total equity. I cannot copy this one

down, I have to redo this– equals 1 plus, because

the numbers are not below. 1 plus, and I have

to go over to 2006 and say debt divided by equity. All right, now I want to check.

Better if I multiply return

on assets times the equity multiplier. Remember, that's a different way

to write the equity multiplier. This times this. That is just so cool. Look at that, I got the

same number there and there. All right. This video was a little

bit about profit ratios and the DuPont analysis. When we come back, we have a

few more ratios to look at. We'll see you next video..