Let's talk a little bit about the DuPont System. It's really called an identity, a DuPont Identity. And it's a way of breaking down, I guess the components of an organization into its atomic elements if you will. Think about a company as if you would, let's say a cake. The cake may look really good but it may taste terrible, or it may look terrible but taste really good, or it may look really good and taste really good or look terrible and taste terrible. I mean there's a lot of different ways that we can think about a cake. A company has the same kind of ingredients. There's profits, there's ways that we use our assets. There's debt that we take on, leverage, and there could be good combinations, and bad combinations of these elements. And just like a cake the company has to come together in the right way in order to taste good, if you will. The DuPont Identity or the DuPont System allows us to break down a company into its individual components and identify each of the components and identify whether or not the organization, the company, is doing well or doing poorly. Let's look at the DuPont Identity really quickly here and show you what I'm talking about. One of the ways that we can identify if a company is being successful is this thing called return on equity. It's that net income as a ratio of equity. Here I have this as the top equation here. Our net income of course is from our P&L statement, our income statement and our equity is from our balance sheet. The net income per equity tells us the return on owner's equity. So if you own stock in a company, you have ownership. You want to know how much money, bottom line, am I bringing on as a result of my ownership. And of course, you would feel better about owning a company that has higher net income as a ratio of your equity. So for each dollar of ownership, you want the company to generate more net income. So a higher ROE, return on equity, is a good sign. Just like a cake tasting good, but why does it taste good? Why is the company doing well? Well, what we can do is we can break down this ROE, the net income has a ratio of equity into some smaller components and let's do that here. Let's suppose that we've got our net income and we also have our equity and that's what we call our ROE. Now we can multiply this equation by one and then we can multiply it by one again and multiply it by one again. There's no problem in that. The one I'm going to multiply by is the ratio of sales to sales. Sales over sales is one, so there's no problem with me adding this to this equation. And then I'm also going to add it over here. I'm going to add another one, assets as a ratio of assets. So whatever the sales are or whatever the assets are, if I take sales over sales and assets over assets, those numbers turn into one. So I am taking my ROE, my net income as a ratio of equity, multiplying it by one, multiplying it by one again. Of course the first one is sales over sales. And the second one is assets over assets. Remember our sales come from our P&L statement, it's the top line of our P&L statement often referred to as revenues. And our assets comes from our balance sheet. It's the left hand side. Now, I am going to rearrange the terms. Some of the terms on the numerator and some of the terms on the denominator and this is not a problem. A times B times C is the same as A times C times B or B times C times A, order of operation doesn't matter. Not when you're just talking about multiplication here. So what I'm going to do is I'm going to take this net income in the numerator. But instead of dividing it by my equity, I'm going to move this sales one over to the left here and I'm going to divide this by sales. It's no problem,right? And then this sales here I'm going to leave this sales exactly where it is. But what I'm going to do is I'm going to move this assets one place to the left as well. And then I'm going to leave this assets over here and I'm going to move this equity all the way over then the furthest spot on the right. So now I have, really the same equation, it's just expressed slightly differently, okay. What is the power of this equation relative to the first equation? The first equation, ROE, net income over equity just says, how much income to I generate for each dollar in equity? The second equation, net income over equity times sales over sales times assets over assets, the same thing as ROE times one times one. But when I rearrange the terms on the bottom here, that's denominator. Now I've got three separate calculations, three separate ratios. This first one, net income to sales, you might recall that is the net profit margin. My sales to my assets is the thing called my asset turnover ratio. And my assets to my equity is called my equity multiplier. So how do we use these? We're going to look at two different companies and identify why it is that one company was more successful than another, by looking at the net profit margin, the asset turnover ratio, and the equity multiplier.
