Sample frameDay 120·Finance · Returns

Morning. Your return on capital is an average of three things. One of them is just borrowed money.

Finance.

The DuPont Decomposition

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The question

Your business earns some return on the capital tied up inside it. Could you say this morning whether that return comes from what you charge, from how hard your assets work, or from how much of the place is funded by somebody else? Two of those you built. One of them you borrowed.

The idea

Return on investment isn't one measurement. It's two multiplied together: the margin earned on each dollar of sales, and the number of times a year those sales turn over the capital sitting in the business. Donaldson Brown worked that out at DuPont in 1914, five years after arriving as an electrical engineer in the sales department and talking his way into the treasurer's office. The consequence is that two firms reporting an identical return can be built in opposite directions — one earning a fat margin on capital that barely moves, the other earning almost nothing per sale on capital it turns over constantly. Brown carried the system to General Motors in 1921, where as finance chief he made the decomposition the instrument by which head office judged every division, and where Alfred Sloan built his divisional structure on it. A later extension added a third term, financial leverage, which lifts the return to owners without improving anything underneath it. One number hides all three.

The framework

01
Split the return in two before you split it in three.
Start where Brown started. Return on capital is margin, which is profit divided by revenue, multiplied by turnover, which is revenue divided by the capital employed. Both terms come off documents you already have: the P&L gives you the top, and the balance sheet you learned to read on Day 38 gives you the bottom. Do it for three years rather than one, and write the two side by side. A return that held steady while margin fell and turnover rose isn't a stable business. It's two opposite movements that happened to cancel, and the single figure was never going to mention it.
02
Jeweller or supermarket?
High margin with low turnover is the jeweller: few transactions, a great deal of value in each, capital sitting on the shelf for months. Low margin with high turnover is the supermarket: pennies an item, but the shelf empties and refills constantly. Neither is superior, and the standing error is importing a benchmark from the other kind of business, so a services firm judges itself against a distributor's margin, or a distributor panics about a margin that wasn't the point. Ask which of the two you're built to be, then ask whether three years of decisions have been quietly moving you towards the other.
03
The third term is leverage, and it improves the ratio without improving the business.
Extend the decomposition to return on equity and a third multiplier appears: total assets over shareholders' equity, which is simply how much of the place is funded with other people's money. Borrow more and that term rises, and the return to owners rises with it, while the margin and turnover underneath haven't moved a fraction. Nothing was improved. The same business is being amplified, in both directions, which is why the term that lifted your number this year is the one that does the damage in a bad one. Before reading a rising return on equity as evidence that something is working, check which term did the work.
04
One term, one quarter.
The point of splitting is that the three terms answer to entirely different moves. Margin answers to price, to what you sell alongside it, and to what you pay for the things you sell. Turnover answers to stock sitting too long, to invoices that sat unchased, to a building or a fleet or a machine doing less work in a year than it could. Leverage answers to how you fund the place, which is a treasury decision and not an operating one. Find the term that moved against you and give it the quarter. Chase all three at once and you won't know at the end which of them paid.

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