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.