 Hello, and welcome to the session. This is Professor Farhad, in which we will discuss return on equity. We are going to decompose this ratio. This ratio is very important because if you remember from prior session, the growth rate of the company is dependent upon the return on equity. So we'll take return on equity times the plowback or what we called the retention ratio. What we keep times what we can earn, that's gonna determine the growth of the company. But in this session, we're gonna take the ROE and break it down into various components using the Dupont analysis. Before I start, I would like to remind you to connect with me on LinkedIn. If you haven't done so and subscribe to my YouTube. Like my lectures if you like them and share them. On my website, farhadlectures.com, you will find additional resources for this course, your accounting courses, and specifically for your CPA exam. Also, you can see how well your university overall scoring on the CPA exam. And this will tell you how rigor is your accounting program. I don't replace your accounting courses if you have Becker, Roger, Glyme, Wiley or Sergeant or any other course. I don't replace them. I am a compliment. If you add me to those courses, I will help you tremendously because I explain everything in details. Those CPA courses, they assume, you know, certain level of material. The assumptions that they make is what I feel for you. If something you're not aware of, you don't know in depth, you did not cover in college, you can rely on my website to help you with that. So let's go ahead and start to decompose return, the important ratio return on equity. Simply put, return on equity is net profit divided by equity. Simply put, how much profit the company made or net income divided by equity. For example, if the company made $100 an income they have 10,000 of equity, return on equity equal to 10%. And this is basically the most basic formula for return on equity. Now, if you want to understand the company further, we want to break down this component into this ratio into five different elements or components. And we can understand each component separately. And those are the five elements. I'm going to show you the five elements and show you how they cancel each other out, how we end up with net profit divided by equity. Then I'm going to go into each component separately, explain it separately, show you how it affects return on equity, then put the whole formula together. So simply put, we're going to break it into the following five ratios. Net profit divided by pre-tax profit, pre-tax profit divided by EBIT, divided by sales, sales divided by asset, asset divided by equity. By equity, notice what's going to happen. I can't cancel, cancel, cancel, cancel everything. What I left with is net profit divided by equity. And this is, this is basically, in other words, in other words, what I'm trying to tell you, this five piece formula equal to this formula, the only thing is when we break it down, we're going to learn more about the company. We're going to learn more about the company. This way we can properly analyze how well the company is doing. I'm going to start with EBIT divided by sale. EBIT divided by sale is also called margin. Margin is very important for any company. You want to know how much a company is earning for every dollar in sales, earning before interest and taxes. In some textbook, they call, rather than they use EBIT, they use net income, okay? And then numerator. I use EBIT because for finance, we use EBIT because we factor out interest and taxes, because we're going to analyze interest and taxes separately in this formula. So what is EBIT? Let's assume again, we have EBIT of 10, sales of 100, that's equal to 10%. But what does 10% mean? It means for every dollar we are making in sales, so the denominator is sales, we are keeping $10, which is equal to 10%. So after we pay cost of goods sold, so simply put, it would look something like the sales minus cost of goods sold, minus operating expenses equal to 10, and we're started with 100. So we consume here 90. So for one, every dollar in sales, we are keeping $10, this is what 10% is. This is EBIT, before we pay interest, before we pay taxes, okay? So this is what EBIT is. Obviously you want EBIT to be the higher, the better. EBIT the higher, the better, not EBIT. Sorry, the margin is higher, the better. Obviously EBIT the higher, the better relative to sales. So to increase EBIT, sorry, to increase the margin, either increase your EBIT without increasing sales or increase EBIT and sales, but EBIT and faster than sales. So you wanna keep more from the money that you are selling. Okay, so this is the first component, is margin. The next component is what we called asset turnover or simply turnover, and this is another important component of this ROE computation. Okay, let's use the same sales. If we have a sales of 100, let's assume assets of 200. 100 divided by 200 equal to 0.5 or 50%. So what does it mean? Our turnover is 50%. Well, the turnover is a utilization ratio. It tells us how well the company is utilizing their assets. So simply put, they have $200 in assets, and from those assets, they are generating $100 in sales. So they are milking $100 in sales. In other words, 50%. In other words, for every dollar in assets, they are getting 50 cent per sale. Now, do you want this ratio to be higher? Of course you want it to be higher. How can you make it higher? Well, increase your sales or reduce your assets. Or if you could do both at the same time, that will be good. You become more efficient. You are generating more sales with less assets, but right now it's for every dollar in assets, you are generating $50 in sales. Now those two ratios are important and we're gonna revisit them at the end of this lecture, little bit much more in details, because they are important. Those two ratios together gives us ROA, return on asset, which is okay. If you really think about it, we can eliminate sales, and what we're left with is even divided by assets, which is return on asset. And again, I'm gonna revisit this ROA, which is an important component of ROE. So ROE, part of it is ROA. You return on asset and explain to you the relationship between those two. There's an important relationship practical in the business world, but we'll revisit this later. Now, so we're done with two out of the five component of the D-Pen analysis, basically those two. Let's keep going. The third one I'm going to cover is assets divided by equity. Now I'm gonna start by telling you, if I have no debt, well, let's start with the simple equation assets. Hopefully you remember this from accounting, equal to debt or liabilities, it doesn't matter. When I say liabilities, I mean debt plus equity. Simply put, if I have $100 in assets, $30 in liabilities, I will have $70 in equity. Let's assume I have $100 in asset, zero debt, it means I have $100 in equity, okay? So simply put, if I have no debt, if I have no debt and I'm relying on equity, simply put my assets would equal to my equity because I have that equal to zero, liabilities equal to zero. So if I have no debt, this ratio is like non-existent equal to one, because if I have 100 divided by 100 or 100 million divided by 100 million, that's gonna give me one. Basically this ratio equal to one, with basically it does not exist. In other words, if the company has no debt, you know, this ratio does not affect anything because if you multiply something by one, it doesn't really matter. But if you have that, what's gonna happen is, this ratio will be greater than one. So this leverage, it's called specifically, it's the leverage component. It's called the leverage component. This ratio will be greater than one. What does that mean? For example, here, if you have 100 in assets and 70 in equity, you're gonna have a ratio that's a greater than one. Now, is this good? Is this bad? Well, remember that, that is risk. Well, if your leverage goes up, okay? What happened is your risk go up. But if your risk go up, your return goes up. But remember, risk is a double-edged sword. If you cannot cover the cost of interest, right? It will work against you. If you can cover the cost of interest, then leverage will work for you. And we saw this in the prior session. So simply put, the higher the leverage, the more that you have, the riskier you are. So if you are one, you have no debt. Once you go greater than one, then you have more debt. So let's just give you an extreme, well, an extreme, but let's assume we have 100 in assets, $80 in debt and $20 in equity. Let's compute this and show you what the ratio will be. So here, what we're talking about is 100 divided by 20. So let's take 100 divided by 20 is five. What does that mean? It means for every $1, the investors are investing in the company. For every $1, the investors are investing, you have $5 coming from debt holders. It means the company is highly leveraged. Again, is this good? Is this bad? Well, as long as you can cover the cost of debt, which is interest, then you are good. Then there is no problem whatsoever. But if you can't cover the cost of that, then you are in trouble. Now, if the ratio is more than one, it means you have debt, then we have to compute a new component of the formula, which is pre-tax profit divided by earnings before interest and taxes. Now, let's walk through a formula of small income statement, partial income statement. So we see how this all works. But again, if those two numbers are equal to each other, if we have 100 in assets, 100 in equity, it means we have no interest. If we have no interest, the numerator here and the denominator here, they will equal to each other. So this pre-tax profit is the same as EBIT earnings before taxes, okay? So if we have no interest, then EBIT, EBIT divided by EBIT should equal also to one. So those two will not exist if we don't have debt. But since we have debt, then we have to find out, what is our interest burden? How much interest is burdening the company? So here's what happened. Let's assume we have earnings before interest and taxes. I'm gonna make up some numbers of 120. Then our interest equal to 20, okay? Our interest equal to 20. Now we have earnings before taxes equal to 100. So what we're doing is this. We are taking 120 here and we're taking earnings before taxes, which is EBIT. This is the EBIT 100, okay? So we want this number to be as close as possible to one. The closer to one this number, the lower is our interest burden. Simply if it's one, it means if it's one, what does one mean? That means you have zero interest because now EBIT and EBIT equal to each other. But you want this closer to one. Closer to one, it means this number is small. You want this ratio to be as close as possible to one. If you have interest, it cannot be one, okay? But you want it to be closer to one. Again, this ratio two and five, they are related because they are affecting the leverage of the company. Matter of fact, those two ratios together, they are called the compound leverage factor. The compound leverage factor, which is the interest burden, which is this formula, this ratio, multiply by the leverage, this ratio. Those two together, they affect the leverage of the company. And we'll see how they affect the leverage in a company in a second, in a larger example. So let's go back and put the numbers here. We said EBIT, I said 120. We have interest equal to 20. I'm just making these numbers up. It means EBIT or here, pre-tax profit for us is 100. Let's assume we're paying 20% taxes. So taxes 20%, that's $20. So profit after tax equal to 80. Now we want to know what is our tax burden. So we wanted to know our interest burden through formula two, through ratio two. We want to know our tax burden. Again, same concept with tax burden. We want the tax burden to be as closer as possible to one. An extreme example, let's assume we have, you don't have to pay taxes. If your taxes are zero and your profit is 100, if your net profit is 100, 100 divided by 100 equal to one. Now that's not the case. We said we have to pay $20 in taxes. Therefore our net profit is 80. Now it means 80 divided by 100 equal to 80%. So again, we want this number to be large. We want this ratio to be large and the closer to one, the better off we are. It means we don't have a lot of tax burden. So why did we do this? Why did we went through all of this and broke down ROE? Well, the reason we broke it down, I'm gonna revisit this a little bit more in details. Later on when we cover ROA in a minute or two is because we wanted to know what affects our return on equity. So if you're a shareholder, what is making you profit? Is it, and we're gonna find out, is it the profit margin that the company is experiencing, is generating? Is it the asset turnover? Is it that they're using a lot of that, a lot of leverage? How much interest is being taken from my profit? What is the burden of the tax? Maybe we need to move to another jurisdiction. So breaking down those ROE into five components, analysts as well as owners, and at least then owners can look at their company, look at the company and analyze it under a new light, under a new light. So this is the beauty of ROE. Decomposing ROE will give you a better picture exactly what's going on within the company. Now to see this a little bit further, the effect of it just to play with some, not to play with some numbers, we have some numbers. Let me show you how it all fits together. We're gonna start with a normal year and we have two companies, know that and some that and the computation already done, all done for you. So let's start with a normal year where the company would know that the return on equity equal to 8%. Well, we're starting with their net profit divided by profit over tax. Same thing that I said, that I compute at 0.8. So they have 80 divided by 100, which is 80.8 or 80%. Here, because they have no debt, pre-tax profit over EBIT equal to one. Because guess what? Because when they got to EBIT, they deducted the interest, which is zero, they came up with pre-tax or EBIT. I wish they used EBIT here rather than pre-tax profit. So those are equal to each other because we have no interest, interest was zero. And this will always be the case if you have no interest. Then we have EBIT earning before interest and taxes divided by sales, their profit margin equal to 10%. Their sales turnover, wow, is one. It means for example, if they have a million of assets, they're generating a million of sales, that's fine. And assets should equal, assets divided by equity equal to one. This makes sense because this company has no debt. It means if zero debt, asset equal to equity. And the compound leverage, which is two times five equal to one because one times one, I'm sorry, one times this one equal to one, right? Because they have no debt, they have no interest, therefore equal to one. So this is the normal year no debt. Let's assume we have some debt. ROE, it's gonna be 0.91. All what we did now is we changed the capital structure of the company. As we change the capital structure of the company, certain numbers don't change. This number don't change. This number don't change. This number don't change. What's gonna change is your leverage. You have more debt, therefore you are leveraged. And obviously if you have that, ratio number two will change as well. Here we are assuming you have that and you earn more than the cost of that. As a result, your return on equity went up 1.1%. So notice how using that will increase your equity and will increase your return on equity. Why? Because you're using other people's money and shareholders because they have less equity. Therefore, they share more in the profit. Now, let's assume it's a bad year and you have no debt now. Now we're gonna use a scenario of bad years. You have no debt. Well, the numbers return on equity equal to 4%. Simply put, the numbers will be very similar. Very similar to no debt, 80%. No debt, one to one. A margin is now you are earning rather than 10%. You are earning 6.2. You're selling less. You're asset to equity ratio equal to one. So overall, notice what happened. If you have no debt and you have a bad year, your ROE is cut in half. Now let's assume you have some debt and what happened to your ROE? If you have some debt and it's a bad year, so you cannot cover the cost of that, your ROE goes from 9.1 to 2.4. So this is the effect of debt. When you cannot cover your debt, expense, and you are leveraged and you go through a bad year, you get really hammered, okay? Why? Because here the compound leverage is 0.6. You have some debt, it's affecting you negatively. Well, on the other hand, if it's a good year, if it's a good year, your return on equity would know that equal to 12%, okay? However, if you have some debt and it's a good year, your return on equity equal to 15.7. And this shows you the effect, the positive effect of debt in good years. Here you have, you are leveraged 1.667. You have, so two and five, you have two and five, you have two and five that are high, which is good, you want that because you're in good years, you're gonna do tremendously well, okay? So this is how it all fits together. So debt is a double-edged sword. In good years, you will do well. In bad years, you will get penalized, okay? And how do we do this? By broken into the, by broken it down by the Dupont analysis. I wanna go back and revisit ROA because I told you, ROA is very important in computing return on equity because ROA has nothing to do with leverage. ROA only deals with how well the company is operating the business because you want to look at ROA. The first thing is, you know, why? Why ROA is important? Let me just tell you why because let's think about it. Number five, number two, and number one, which is your tax burden, your interest burden, and your leverage. Two and five has to do with your financing policy, how you finance your company. Number one has to do with the government. You have no control over that. Or you might have some control, maybe you can move out, move from that jurisdiction, but in a sense is if you can't move, you cannot control the tax burden because the government imposed that on you. Therefore, what's important to look at when you're analyzing ROE is ROA. It doesn't mean the other one are not important. What I'm trying to say, the ROA tells you exactly how well business is doing. And basically we're gonna be looking at two ROA, one for a supermarket chain and one for the utility company. They both have a 10% ROA. But if we look at margin times as a turnover, we notice that the supermarket, they only make 2% and that's pretty high margin. It means for every dollar they sell, they only keep two pennies and for every $100, they keep $2. That's not a high margin. However, their asset turnover is pretty high. It means for every dollar in sales, I'm sorry, for every dollar in asset, they generate $5 in sales. Their asset turnover, five over one, it's pretty high. And this is how they come up with 5%. The utility company, they have a high margin. It means for every dollar in sales, they keep 20 pennies. That's pretty high, decent margin. However, their asset turnover is low. It means for every dollar in assets, they only generate 50 pennies in sales. That's why their asset turnover equal to 0.5. But overall, when we look at the end at ROA, equal to 10%, they both equal to 10%. What is the point that I'm trying to make? The point that I'm trying to make is this. No company, no company, at least on a permanent basis or semi-permanent basis, maybe for a short period of time, could be high on margin and high on asset turnover. Let's think about it. Let's think about this. They cannot be both high at the same time. Let's take Apple as an example. The Apple, when the iPhone came out, when the iPhone came out, for a short period of time, Apple had the monopoly. In other words, they had no competitors. They could sell the, if you want to buy the phone, you have really no other option, quasi-monopoly. So what happened is when you have that type of power, you can charge high prices. High prices gives you high margin, high profit margin, and you can sell a lot because you have no competition. What happened then? Well, if that's the case, if a company is experiencing high margin and high asset turnover, what happened naturally, other companies will go into that market and will start to chip on them. They will start to take away either their profit or their sales. So if Apple wants to keep the high margin, they can. But once Google comes with a new phone and start to take sales from them, asset turnover will start to decrease, will go back to normal. Therefore, if they want to keep a high margin, asset turnover will go down. Well, let's assume Apple chooses to have more sales. Well, if they want to have more sales, that's fine. If they want to sell more, they have to lower their prices. Therefore, their margin, their profit margin will go down. So simply put, there's always that pull and push between margin and asset turnover. And this graph will clearly shows us, this is a turnover for 45 different industries. So it's not even a company to say, well, maybe it's skewed one way or another. We're talking about industries. For example, here we have the food stores generally supermarket. They have, this is the profit margin on the Y-access. This is the X-access and this is the Y-access. On the X-access, we have asset turnover. They have a turnover of three, which is pretty high. Pretty high. So they're to the right, this is pointed to the right. But notice, their operating profit is what? Their operating estimate may be two, 2%. So notice, their turnover is high, but they don't make a lot of money on every dollar in sales. If we look at this company here, I don't know in what industry this is, but we're looking at it here. They have a high profit margin, which is approximately 23%. That's a high profit margin. But when we look at their asset turnover, it's 0.4. So in other words, you cannot be here. You cannot be here. What does it mean to be here? It means you have a high asset turnover. You have a high asset turnover and high operating profit. It doesn't work that way. And if you do experience that, you'll experience it for a short period of time. And if you experience it on a permanent basis, rest assured, Uncle Sam will intervene and they will break you up because this is a monopoly when you can sell a lot and make a good profit margin. If that happens, you just basically, naturally you invite the competition and assume when you are operating in a capitalistic society, competition can enter that industry and start to chip away either from your margin or from your sales. Then you'll go back to normal. So a company could be out here for a short period of time. Then it will go back to the normal ROA asset turnover interception, basically some place in here. This is basically kind of not an efficient frontier, but basically it's very hard to cross this, to cross this, to be here or to be here or to be here. You might do it for a short, for example, this is computer peripheral. It's outside. That's good. They have a very high profit margin and a decent, relatively a decent asset turnover. But let this will be maybe for a short period of time. Then once the competition comes in, it's either they have to, this will go lower. In other words, their profit margin will go down or their asset turnover will go to the left and they'll go back to within the overall industry. Now, if you like this recording, please like it and share it. Again, I'm going to invite you to my visit, my website, especially if you're a CPA candidate or accounting student. If you're a CPA candidate, keep your CPA course. I cannot replace it. I wish I can, but I can have an addition to your CPA course, lectures like these plus practice questions to help you prepare for your CPA prep course, help you succeed on the CPA exam. The CPA exam is a lifetime investment. Take it seriously. And once you pass, that's it, one time, you don't have to do it again. So invest in your time and career. So you'll put it behind you and focus what you need to focus on. Good luck, study hard and stay safe.