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“Back friends get excited because today we re going to talk about the dupont equation. Equation. The dupont equation is one of the most important innovations in business. But before get to the equation.

I need to tell you the story about how this all came about most of you know that dupont is a chemical company and has been one of the largest companies in the world for a very long time. The dupont equation was developed by a man named donaldson brown. Now donaldson brown is one of my personal heroes. And he did accounting in corporate finance at the dupont company.

This guy had an amazing career. So he actually started by getting in an engineering degree from college. And he started working in the explosives division at dupont and he was so successful that he actually became the manager of the whole division now. This is where it gets interesting.

Because he left that position to join the treasurer s office. Now we all know that the treasurer s office is an accounting department in a company that manages all of the company s money. It was his time in the treasurer s office. When he developed the dupont equation.

So dupont is the first example in recorded history that i can find where a company developed a business laboratory..

So dupont had the secret room that they called the chart room and in the chart room donaldson would create all of these financial charts. And so the leadership of the company would come into this room donaldson would present this financial information. They would apply the dupont equation and then make financial decisions meanwhile dupont made a large investment in general motors and as donaldson progressed in his career. He became the vice president of finance at general motors eventually he became the vice chairman of the board of general motors so this guy had an incredible career.

He started out as an explosives expert and eventually became a member of the board of general motors. And what you have to understand is that during this period of time when he was doing corporate finance at general motors general motors became the largest corporation in the world. I m gonna put up a photo of him this is the dupont executive committee in 1919. Donaldson brown.

Is the only person wearing a light suit now i don t know if you forgot if it was picture day or not or if he was just so radical that he wanted to stand out from everyone else. But he certainly stands out in this picture now that we know the history. Let s get into the equation. You have to understand what donaldson was trying to do here.

So donaldson was sitting in the treasurer s office. Doing corporate finance and corporate finance. Is all about looking at the money you have and trying to decide the best use for those funds dupont had all of these different divisions. And so donaldson is looking at the money.

He has and he s trying to make the decision on what is going to be the best return on investment now in the 1910s..

The concept of return on investment was not very well defined the great innovation from donaldson was that he had the insight that you could define return on equity using three accounting ratios profit margin asset turnover and financial leverage now i ve talked about all three of these accounting ratios in other videos over the last couple of weeks. So i m not going to talk about them here in depth. What is important to understand is the relationship between these ratios can help you understand return equity donaldson started with the accounting ratio return on equity. This is net income divided by owner s equity.

This ratio describes that the owners put a certain amount of investment into a business. Which generates a certain amount of profit each year. This is useful information. However it would be helpful to be able to drill down and understand what is driving return on equity that is what the dupont equation achieves the dupont equation says that return on equity equals profit margin times asset turnover times financial leverage this works because when you multiply these three ratios sales and assets cancel each other out and you are left with net income owner s equity or return on equity you will also notice that profit margin times asset turnover is the same as return on assets which is our good friend productivity you can then shorten this equation to return on equity equals productivity times financial leverage.

This tells you something very important obviously owners care about productivity. But they also care about something else from an owners perspective capital structure. Really matters. You want to know how much of the assets in a business come from owner s equity and how much comes from debt.

Let s go back to donaldson. So if he is gonna take this money and make an investment in a company. He s going to want to understand return on investment or return on equity. The dupont equation tells us that return on equity for any organization is driven by only three things profit margin asset turnover and financial leverage each company has at the three dials which you can turn up or you can turn down any changes in these ratios will flow through to your return on equity.

This is really powerful for company leaders because you can control your organization with these three dials you can take any of these dials and crank it up or crank..

It down let me give you some examples profit margin is driven by sales. So you can ask the question can you more narrowly define your value proposition to meet market demand asset turnover is driven by operations you can ask yourself the question here can you increase the efficiency of your operations financial leverage is driven by your credit here you can ask the question can you improve your credit rating. I hope you can see that this equation is allowing you to understand what is driving your return on equity and showing. Where you have opportunity to improve the big takeaway for me in this equation is the importance of financial leverage.

So productivity is obviously important. But what this equation tells us is that you can take productivity. Which is profit margin times asset turnover. You can take that and use financial leverage to ramp it up as your credit rating increases for example.

Imagine you have two businesses with exactly the same productivity. One company has 100 owner s equity while the other company is 50 owner s equity and 50 debt. The company with debt has double the return on equity they are taking the same amount of productivity and doubling it however in order to achieve this the second company has to have a high enough credit rating to take out that much debt let us use. Another example.

Imagine you have a restaurant with no debt. That performs really well now imagine you were to open a second restaurant on the other side of town also imagine that instead of using your own money to pay for that new restaurant you went out and funded it through debt. Now you have two restaurant locations. Assuming the productivity is the same at each location you just doubled your return on equity without having to invest any more money the key to all of this is your credit rating.

Now typically when you first open a business..

You don t have any credit history. And so people aren t gonna be willing to lend you money on very good terms. But if you ve been in business for say ten years and you have a positive track record of consistent revenues and a strong balance sheet. You re going to be able to find people to lend you money you have to build your reputation to have good credit and the way you do this is through accounting you need to make debt payments on time pass your financial audits have a robust accounting system and have a strong accounting team if you do these things that s going to allow you to access better capital markets.

And that allows you to better leverage your money. This is one of the reasons. Why accounting is so important accounting is one of those careers. Where you can really impact people s lives think about this on a global scale.

So humanity as a whole has a certain amount of productivity and a certain amount of capital to invest so if we were to take everybody in society and raise their credit rating by making more fiscally responsible choices. We could ramp up return on equity for the entire planet accountants can do this donaldson did it for dupont and general motors and now we have an opportunity to do this for the entire world now i want to hear from you if you think the dupont equation is important go ahead. And leave a comment down below let me know what you think. And if you found this video.

Helpful. If you liked it go ahead and click on that subscribe button. The best way to supercharge of business is through accounting and corporate finance and i release a new video every week. So come ” .

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