From the course: Accounting Foundations

Common ratios: ROE & DuPont framework

From the course: Accounting Foundations

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Common ratios: ROE & DuPont framework

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- [Instructor] 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 computed by dividing net income by equity. ROE is a measure of the amount of profit earned per dollar of owner investment. In 2024, Walmart's ROE was 18%. ROE for Target was 31%. This means that shareholders who invested $100 in Walmart earned profits of $18 in 2024. If those shareholders had invested that same $100 in Target, they would've earned $31 in profit. 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 2024, the Walmart shareholders didn't do as well as did the Target shareholders. 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. 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. Here is that decomposition. 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 efficiency in using assets to generate sales. Assets to equity is the number of dollars of assets purchased for each dollar of owner investment in the company. Now, 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 2024 numbers to compute the DuPont Framework ratios for Walmart and Target. And let's use the DuPont Framework numbers to answer this question, why was Walmart's return on equity in 2024 only 18% when Target's was 31%? We quickly find one of the biggest reasons for the difference right there in the first DuPont Framework dimension, profitability. The profit margin or return on sales numbers show that in 2024, $100 in Walmart sales resulted in net income of only $2.50. Whereas the same $100 in Target sales resulted in net income of $3.90. In 2024, Target controlled its expenses better, so it was able to squeeze more profit out of each sale. Now, what about efficiency? The asset turnover numbers show that actually, Walmart was more efficient than Target at using its assets to generate sales in 2024. $1 of Walmart assets generated $2.57 in sales. Whereas $1 in Target assets generated only $1.94 in sales. This DuPont Framework analysis indicates that 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 been able to buy $4.12 in assets by combining that $1 of shareholder investment with $3.12 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. The DuPont Framework analysis allows us to quickly see that Walmart's 2024 return on equity was so much lower than was Target's. The primary reasons? Walmart's 2024 profitability was much lower and Target's use of leverage was much higher. 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, its ROE.

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