Du Pont formula: Difference between revisions
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'''Du Pont formula''' is a formula that expresses the relationship between [[return on assets (ROA)]], sales-to-assets, [[profit]] margin and measures of leverage<ref>Brealey R. A. i in. 2018, | '''Du Pont formula''' is a formula that expresses the relationship between [[return on assets (ROA)]], sales-to-assets, [[profit]] margin and measures of leverage<ref>Brealey R. A. i in. 2018, p. 768</ref>. An extended Du Pont formula measures ROE which gives us information about the returns earned on the owner's [[investment]]<ref>Shim J. K. i in. 2012, p. 337</ref>. | ||
==The Origin of Du Pont Formula== | ==The Origin of Du Pont Formula== | ||
E. I. Du Pont Nemorous Powder Company was the leading [[firm]] manufacturing high explosive materials in early 1900. Later it grew into one of the world's largest chemical companies. Du Pont managers developed the concept of '''[[return on investment]]''' to control and evaluate its operations<ref> Lal J. (2017)</ref>. | E. I. Du Pont Nemorous Powder Company was the leading [[firm]] manufacturing high explosive materials in early 1900. Later it grew into one of the world's largest chemical companies. Du Pont managers developed the concept of '''[[return on investment]]''' to control and evaluate its operations<ref> Lal J. (2017)</ref>. | ||
The financial unit traced the '''[[cost]]''' and '''revenues''' for each [[product]] produced. This gave accurate [[information]] on profits, which provided a more precise way of evaluating [[financial performance]]. However, managers found product-line profits to be an incomplete measure of performance because these did not indicate the '''rate of return''' | The financial unit traced the '''[[cost]]''' and '''revenues''' for each [[product]] produced. This gave accurate [[information]] on profits, which provided a more precise way of evaluating [[financial performance]]. However, managers found product-line profits to be an incomplete measure of performance because these did not indicate the '''rate of return''' on capital invested<ref> Lal J. (2017)</ref>. | ||
Developing a rate of return on each segment of business required accurate data on investment. Du Pont undertook a careful valuation of each of its plants, properties and inventories by product line. With this information, [[management]] could track return on investment by product line<ref> Lal J. (2017)</ref>. | Developing a rate of return on each segment of business required accurate data on investment. Du Pont undertook a careful valuation of each of its plants, properties and inventories by product line. With this information, [[management]] could track return on investment by product line<ref> Lal J. (2017)</ref>. | ||
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==ROA and ROE ratio== | ==ROA and ROE ratio== | ||
Du Pont developed ways to measure ROA and ROE ratios. The '''[[return on assets]]''' ratio developed by Du Pont breakdowns ROA into the product of [[turnover]] and margins <ref>Brealey R. A. i in. 2018, | Du Pont developed ways to measure ROA and ROE ratios. The '''[[return on assets]]''' ratio developed by Du Pont breakdowns ROA into the product of [[turnover]] and margins <ref>Brealey R. A. i in. 2018, p. 768</ref>. | ||
When the firm raises cash by borrowing, it must make interest payment to its lenders and this reduces net profits. However, if a firm borrows instead of issuing equity, it has fewer equity holders to share the remaining profits. An extended version of Du Pont formula helps us find out which effect dominates. It breaks down '''return on equity''' into four parts<ref>Brealey R. A. i in. 2018, | <math>\text{ROA} = \frac{\text{After-Tax Interest + Net Income}}{\text{Assets}}= \frac{\text{Sales}}{\text{Assets}} \cdot \frac{\text{After-Tax Interest + Net Income}}{\text{Sales}}</math> | ||
Where<ref>Brealey R. A. i in. 2018, | When the firm raises cash by borrowing, it must make interest payment to its lenders and this reduces net profits. However, if a firm borrows instead of issuing equity, it has fewer equity holders to share the remaining profits. An extended version of Du Pont formula helps us find out which effect dominates. It breaks down '''return on equity''' into four parts<ref>Brealey R. A. i in. 2018, p. 770</ref>: | ||
<math>\text{ROE} = \frac{\text{Net Income}}{\text{Equity}}= \frac{\text{Assets}}{\text{Equity}} \cdot \frac{\text{Sales}}{\text{Assets}} \cdot \frac{\text{After-Tax Interest + Net Income}}{\text{Sales}} \cdot \frac{\text{Net Income}}{\text{After-Tax Interest + Net Income}}</math> | |||
Where<ref>Brealey R. A. i in. 2018, p. 770</ref>: | |||
* ROE = leverage ratio; | * ROE = leverage ratio; | ||
* Assets/Equity = asset turnover; | * Assets/Equity = asset turnover; | ||
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==References== | ==References== | ||
* Brealey R. A. (red.), (2018) ''[https://books.google.pl/books?i-d=TQGkDwAAQBAJ&pg=PT1365&dq=%22du+pont+formula%22&hl=pl&sa=X&ved=0ahUKEwjfpL3jhODlAhUBIVAKHTO1DGcQ6AEIPDAC#v=onepage&q=%22du%20pont%20formula%22&f=falsee Principles of Corporate Finance, 12/e]'', McGraw-Hill [[Education]], India, | * Brealey R. A. (red.), (2018) ''[https://books.google.pl/books?i-d=TQGkDwAAQBAJ&pg=PT1365&dq=%22du+pont+formula%22&hl=pl&sa=X&ved=0ahUKEwjfpL3jhODlAhUBIVAKHTO1DGcQ6AEIPDAC#v=onepage&q=%22du%20pont%20formula%22&f=falsee Principles of Corporate Finance, 12/e]'', McGraw-Hill [[Education]], India, p. 768-770 | ||
* | * Lal J. (2017), ''[https://books.google.pl/books?id=TERxDwAAQBAJ&pg=SA11-PA21&dq=%22du+pont+formula%22&hl=pl&sa=X&ved=0ahUKEwjGzNGooeDlAhUEQhUIHXcGAoEQ6AEIKTAA#v=onepage&q=%22du%20pont%20formula%22&f=false Advanced Management Accounting (Text, Problems & Cases)]'', S Chad And [[Company]], New Delhi | ||
* Shim J. K. (red.), (2012) ''[https://books.google.pl/books?id=OXiQUFjnWBMC&pg=PA337&dq=%22du+pont+formula%22&hl=pl&sa=X&ved=0ahUKEwjFltyVheDlAhWJZVAKHWgJCAsQ6AEISDAD#v=onepage&q=%22du%20pont%20formula%22&f=falsee CFP Fundamentals: Your QuickGuide to Internal Controls, Financial Reporting, IFRS, Web 2.0, Cloud Computing, and More], John Wiley and Sons, Hoboken, | * Shim J. K. (red.), (2012) ''[https://books.google.pl/books?id=OXiQUFjnWBMC&pg=PA337&dq=%22du+pont+formula%22&hl=pl&sa=X&ved=0ahUKEwjFltyVheDlAhWJZVAKHWgJCAsQ6AEISDAD#v=onepage&q=%22du%20pont%20formula%22&f=falsee CFP Fundamentals: Your QuickGuide to Internal Controls, Financial Reporting, IFRS, Web 2.0, Cloud Computing, and More], John Wiley and Sons, Hoboken, p. 337-338 | ||
[[Category:Financial management]] | [[Category:Financial management]] | ||
{{a|Michał Dembowski}} | {{a|Michał Dembowski}} | ||
Latest revision as of 08:39, 18 November 2023
Du Pont formula is a formula that expresses the relationship between return on assets (ROA), sales-to-assets, profit margin and measures of leverage[1]. An extended Du Pont formula measures ROE which gives us information about the returns earned on the owner's investment[2].
The Origin of Du Pont Formula
E. I. Du Pont Nemorous Powder Company was the leading firm manufacturing high explosive materials in early 1900. Later it grew into one of the world's largest chemical companies. Du Pont managers developed the concept of return on investment to control and evaluate its operations[3].
The financial unit traced the cost and revenues for each product produced. This gave accurate information on profits, which provided a more precise way of evaluating financial performance. However, managers found product-line profits to be an incomplete measure of performance because these did not indicate the rate of return on capital invested[4].
Developing a rate of return on each segment of business required accurate data on investment. Du Pont undertook a careful valuation of each of its plants, properties and inventories by product line. With this information, management could track return on investment by product line[5].
Return on investment is the product of sales turnover (Sales/Total Investment) and return on sales (Earnings/Sales). With this data, managers can determine the causes of a product's change in return on investment. Du Pont managers used this information to calculate new capital appropriations by establishing the policy that there "be no expenditures for additions to the earning equipment if the same amount of money could be applied to some better purpose in another branch of the company's business"[6].
ROA and ROE ratio
Du Pont developed ways to measure ROA and ROE ratios. The return on assets ratio developed by Du Pont breakdowns ROA into the product of turnover and margins [7].
When the firm raises cash by borrowing, it must make interest payment to its lenders and this reduces net profits. However, if a firm borrows instead of issuing equity, it has fewer equity holders to share the remaining profits. An extended version of Du Pont formula helps us find out which effect dominates. It breaks down return on equity into four parts[8]:
Where[9]:
- ROE = leverage ratio;
- Assets/Equity = asset turnover;
- (After-Tax Interest + Net Income)/Sales = operation profit margin;
- Net Income/(After-Tax Interest + Net Income) = debt burden.
Footnotes
| Du Pont formula — recommended articles |
| Net income margin — Cash earnings — Accounting profit — Market value added — Non-operating expense — Combined Ratio — Economic Value Added - EVA — Return on sales — Net operating loss |
References
- Brealey R. A. (red.), (2018) Principles of Corporate Finance, 12/e, McGraw-Hill Education, India, p. 768-770
- Lal J. (2017), Advanced Management Accounting (Text, Problems & Cases), S Chad And Company, New Delhi
- Shim J. K. (red.), (2012) CFP Fundamentals: Your QuickGuide to Internal Controls, Financial Reporting, IFRS, Web 2.0, Cloud Computing, and More, John Wiley and Sons, Hoboken, p. 337-338
Author: Michał Dembowski
