The Du Pont formula for investment analyst was created by their treasurer, F. Donaldson Brown in 1920 as a way to asses how well they were doing financially. It worked so well it has been copied by others.
How does it work? At first glance it appears to be a simple way of analyzing the money coming three ways: profit margin, total asset turnover, and financial leverage. In other words assessing the money coming in, comparing it to all aspects of money going out and seeing how well a company is doing money wise. What’s so different about that? What did they do that others were not doing?
Apparently they were doing something well, otherwise the little ammunition factory would not have grown, under the able hands of Brown who figured well, to the highly successful chemical company it became. This article attempts to extract some of its essence and know how, beginning with defining terms and phrases that relate to return on investments. (ROI)
First this bit of insight that shows the difference between then and now. Most likely that astute accountant did not rely too much on abbreviated words, but wrote meanings out fully. He would not have much use for acronyms and would have known that figuring them out was time consuming and time meant money. This is an assumption, only.
As an example, when first confronting the word ROI, would he have grabbed a cigar or a dictionary before resuming his monthly analyst of return on investments? Being smarter than that he would probably have not wasted a second, being an efficient observer of all things capital. He would have immediately started tallying, not dilly-dallying.
Efficiency is everything. When that is applied to how much profit one is making, considering the length of time one has started the business and making allowances for operating expenses one would be content when gradually the profit margin is increasing. When it isn’t, a serious flaw has occurred somewhere.
Instead of treating that fact casually, going back over ledgers, purchases, and all available contacts, and everything pertinent to profit will show where the weak link is. It will be corrected before it can become an infestation that will gradually eat away the good intentions of business.
How well the assets are being used to generate more fluidity is a continuing question that must be kept in mind. Is this money allowed to stagnate or is it being used to refurbish, expand and to generate new income. This second step is taken cautiously, but it is taken. A company must never get in so deep that it cannot get to needed money within at least a couple of day, nor should it sit around doing nothing. Astute overseers, as Brown must have been, would have seen that the money coming in not only talked, but worked.
Keeping the books well balanced is what financial leverage is all about. It is not doing without and holding the company back for fear of borrowing and going into debt, but it is how well this money is being used. It is knowing when to extend the company further, or quietly waiting for a better economic climate and a real need before forging ahead.
Financial leverage is also being aware of what will happen if this or this happens, and what are the probabilities of getting in too deep and being unable to pay off debts should the economy take a nose dive. It is being aware of the stability of the companies, the suppliers, and others necessary to keep a business running, or of their instability. However, borrowing is best, if at all possible, when kept at a comfortable, a no-problem level.
The so-called Du Pont formula is indeed a formula, and for those who deal in chemical and other explosive devices and situations and who are chemists at heart, this style of thinking probably comes quite natural, to others who deal in words, they must have it all written out in long sentences with explanations and directions galore.