Financial Analysis Fundamentals: How to Analyze Financial Statements Like a Pro Part 8 | CFI Course

Let's finish off the course by looking at the DuPont Pyramid of Ratios. It's also commonly referred to as the DuPont Analysis. And it's a financial analysis framework that was developed by the DuPont Corporation way back in the 1920s. The analysis aims to assess a company's return on equity, or ROE, by breaking it down into its key components. What's really cool is that it provides a structured approach to understand the factors driving a company's profitability and its efficiency. The standard DuPont Pyramid has three levers, which we will get into in just a second. But we'll start by breaking down ROE into two levers, or two ratios. The trick with this is that we need to make sure that when these two ratios are multiplied together, we end up with return on equity. The first ratio is the return on assets ratio. The ROE ratio is a financial metric that measures a company's profitability in relation to its total assets. It provides insight into how effectively a company utilizes its assets to generate profit. The second ratio is referred to as the equity multiplier, more commonly referred to as financial leverage. It measures the extent to which a company relies on debt financing, and it's calculated by dividing total assets by shareholders' equity. As you can see here, these two ratios can be multiplied together to get return on equity, as total assets in both ratios cancel each other out. Now let's break down the ROE ratio to get the standard three ratio, or three lever DuPont analysis. You can see here that return on assets can be broken down into net profit margin and total asset turnover, and we've seen both of these ratios already. You can see that when multiplied together, that revenues in the net profit margin gets cancelled out by revenues in the total asset turnover ratio. Most financial analysts actually stop with the three ratio, or three lever approach. But in fact, there is a five ratio approach that takes net profit margin and breaks it down into three component ratios. Let's explore those now. Let's start with tax burden. Tax burden is the ratio of earnings before tax to net income. It measures the percentage of pre-tax earnings that are retained as net income after accounting for taxes. A tax burden ratio closer to one indicates that the company retains a larger portion of its pre-tax earnings, leading to a higher return on equity. Next comes interest burden, which is the ratio of earnings before tax to earnings before interest in tax. An interest burden ratio closer to one indicates that the company has little debt. Finally, we have the operating profit margin ratio, which is earnings before interest in tax divided by revenues. Now when we multiply these three ratios together, earnings before tax and tax burden and interest burden get cancelled out. And so does earnings before interest in tax in the interest burden ratio and the operating profit margin ratio, leaving us with net profit, net income divided by revenue. This gives us five ratios that when all multiplied together actually give us return on equity. Now we know that the way a company manages its tax burden, its interest burden, its operating profits, its asset turnover, and its financial leverage all drive return on equity. Okay let's actually interpret a three-step DuPont pyramid. Now I've already filled in the calculations for you so that we can focus on the interpretation. We'll do it for big retailer, we'll then do it for mid-retailer, and then I want you to have a go with small retailer. So what I'm going to do though is we don't need to see these calculations, so I'm going to just hide the cells. I'm using shift F10 and then clicking hide, H for hide. And now what we can do is we can move back, sorry let me go down, let's get to, you can see that we have checks here and the check is basically this. We want to make sure that these three ratios, when calculated, do actually lead to the return on equity. And the okay is saying it's good. And then we actually hide the five-step DuPont pyramid and we have the same thing. Now I'm going to use, and I'm going to focus on the three-step because that is the most common. Yes, there is a five-step, we've already talked through it, you can see it broken down there, but often financial analysts that I work with use the three-step. So I'm going to ask you to turn to the three-step DuPont pyramid and I'm going to ask you to zoom in and we're going to see if we can unlock what's causing the changes in performance. So what we see here, remember with the big retailer, the return on equity was really trending down. So the question then becomes, is that to do with leverage, asset utilization, or profitability? So I'm going to scroll down and we're just going to go years one through to year five, just so you can see how this works. So when we look at net profit margins up to year five, yes, you can see them dramatically go down. So this looks like it's the culprit. There's something to do with the income statement that's impacting return on equity, because you can see net profit margin go from 3.37% down more than half to only 1.3% before recovering. Let's now look at the second. We can see here the total asset to equity. It's roughly the same. It hasn't changed. So this is not where the decline in ROE is coming from. And then let's look at asset utilization. And in fact, for the first five years, that hasn't moved very much. So we know the culprit impacting return on equity is on the income statement driving net profit margin. So now what we can do, oops, scrolled over too far, is I might zoom out a bit just so you can see both, is this is additive. And I'll tell you what I mean in a second. Let me just zoom out. This might be a bit too small. Hopefully you can still see my screen. What I mean by being additive is that I'm going to start at the bottom. If you take gross margins and you then take off SG&A and other operating expenses, you'll get EBITDA margins. So let me just flag it. There's year 826. We take off roughly 20. That leaves about six. We take off another one, right? That leaves about five. And what do we have here? We have roughly five. We then take off our depreciation, which is another two, and we're left with roughly three. We then take off other non-operating expenses, percent of revenue, which is 0.32, and we're left with 3.22%. Finally, we take off tax, which is 0.83, and that leaves us with 2.39%. Remember the way you read this is for $1 revenue, a shareholder gets 2.39 cents in year 8. Now what we're going to do is look to see where we can see the trend. Where is an expense or a margin being impacted? So when we look at gross margins, you can see they're relatively stable. They go from 26 to 27. In fact, they are improving. When we look at our SG&A, we have a bit of a culprit here because that is increasing, but not by a lot. We then look at our other operating expense, not much change there, although it does go up by 1.73%. When we look at our EBITDA margins, we can see that trend is starting to go down. So we know we have an issue in our SG&A, and we want to explore what some of these other operating expenses are because it is impacting that margin. Let's see if we see any other thing. Yeah, depreciation is going up, so that's impacting it. So now we can definitely see that trend. We don't have much change in other non-operating expenses, so we're good there. And when we think about our EBT margin, that trend is self-evident, but we're paying less of it in tax, so it's not a tax issue. So can you see how you can dig into the pyramid? First at the top level, try to diagnose what's going on, and then break it down. Okay, so in this instance, we only really needed to dig deep on the left side of the pyramid. Let's see what happens when we look at mid-retailer. Now let's look at mid-retailer and go through the same exercise. We're starting at the top, return on equity, and what we're going to do is we can see that year one is 16%. By the end of this whole eight years, it's then 28.5%. Now there's a slight dip, it's pretty stable, and then we see a huge increase. So in this instance, let's say we want to investigate what's driving that huge increase in return on equity for year eight. So we're just going to focus on that. Let's look for a large change. When we look at net profit margin, over the period, the net profit margin has improved. It was 1.83. It's been around 2, 2.4, 2.4, and then 2.56. So it has increased, but not by the scale that return on equity has increased. Now let's look at total assets to equity. Here we have a significant increase. We see 2.68 to 3.37. So it's how this company is using its assets or its leverage. So that's also driving it. Let's see if we can see anything on the asset utilization side of the pyramid. So here's our asset turn, and you can see it's pretty stable. And the way you read this, remember, is for every dollar invested in assets, how many dollars of revenues does this company generate? And remember, just put your currency in. If we're in the UK, it would be for every pound invested in assets, how many pounds of revenue are we generating? We can see turnover ratios. So what we can do with the asset turn is we can break it down into the components. But one of the things that's often easier to see is not the turn ratios. These mathematically are more consistent. But what we typically do is we also have that working capital analysis. And let's look at what's happening here for mid-retailer. So our AR days are roughly the same. Our inventory days from year one to year eight are roughly the same. Our AP days are roughly the same. So it looks like their working capital isn't changing very much and our asset utilization isn't changing very much. So it looks like the culprit here for mid-retailer in terms of that improvement in year eight is really, when compared with year one, is going to be our total asset equity. And then you might want to explore some other leverage and coverage ratios. Okay, that's it for mid-retailer. Now let's look at small retailer. So be back in a sec and we'll look at small retailer. Finally, let's look at small retailers three-step DuPont pyramid. Now we can see that if we look at year one, the return on equity was dramatically low. And then we can see it improving. And then year five, it drops quite significantly. It basically halves. But then there is a trend upward, a significant trend. So let's see if we can explore what's happening in years five through eight to drive the return on equity from 6.32 to 16.2. So we do see an increase in the asset turnover, or sorry, total asset equity ratio. But you notice it's not as significant as what we saw for the mid-retailer. So this is helping. But now let's look at the margins. So we go to net profit margin, and this looks like it's the culprit because the net profit margin has more than doubled over the period. Before we dig down net profit margin, let's actually look at asset utilization, just in case we're getting some benefit from how the assets of the business are being utilized. And here we have a situation where, yes, the asset utilization has improved, but not by a significant amount. But certainly it is better. So asset turnover is helping. Our total assets to equity is helping. But the big mover appears to be a net profit margin. So let me zoom out a bit. Well, no, I'll keep it large so you can see this. Let me. So this is our gross margin. And when we look at year five, we definitely see an improvement there, right at the very top. So we're either charging more or cost of goods sold is less because those margins have increased by 3%, which is significant. Let's go back to these next one. Here's our EBITDA margin. You can see 7 to 10. We're still keeping that 3% increase in our margins. Here we have EBIT margin. Again, now we have about 1.5% still significant. And here's our EBT margin. Going up from 3 to. That's an increase of 50%, right? 3 to 4.5, which is where why we see when we look at net profit margin. We can see that doubling. So you can see there's something right at the heart of this business, which is allowing the small retailer to do exceptionally well in the last few years, all the way back to gross margins. So something that's happening with either the prices they're charging, they're able to charge higher prices, or they're able to decrease their direct operating costs. Okay, that's it. See you soon. In this course, you've learned how to conduct a thorough financial analysis by using ratios extracted from the company's three main financial statements. And with this knowledge, you're now better equipped to evaluate a company's financial health using key ratios that reveal profitability, operational asset utilization, and capital structure performance drivers. Additionally, you've acquired the skills to effectively present both trend and benchmarking analyses using real best practices and data visualization. Finally, you should feel more confident in employing the DuPont pyramid of ratios to gain a deeper understanding of what's really influencing a company's return on equity. Mastering the financial analysis of a company's three core financial statements is truly essential for anyone who aims to understand the factors that drive a company's performance. Bye for now.