B2B sales professionals often ask me during Business Advisor training workshops which one financial ratio or KPI metric is most important to CXO Buyers. My standard response is, “It depends on the company/organization and the preference of its CXOs, but if you would like to know the one financial equation that is most important to CXO Buyers, I would say it’s the DuPont Formula.”
At this point in the conversation I would normally see a blank face staring back at me. Invariably they would ask, “What is the DuPont Formula?”
As a CFO, I Couldn’t Survive Without the DuPont Formula
As a CXO Buyer (F500 CFO), I leveraged the DuPont Formula almost every day – analyzing and reporting financial results, evaluating operating management performance, calibrating incentive plan payout targets, presenting to Wall Street stock analysts and Boards of Directors, and most importantly, financially-justifying new investments in OPEX (operating expenditures) and CAPEX (capital expenditures).
I’m not prone to hyperbole, but I could not have discharged my responsibilities as a corporate CFO without leveraging the DuPont Formula as a guiding financial framework for my decision-making.
B2B Marketers Should Consider Using the DuPont Formula as a FINANCIAL IMPACT Framework
The DuPont Formula offers B2B Marketers a comprehensive framework for demonstrating the “hard” financial impact of their solutions on their customers’ financial statements, financial ratios, and KPI metrics. The breadth of potential financial impact provided by one financial formula, the DuPont Formula, is impressive. It encompasses 12 different financial impact areas:
- 3 Income Statement categories
- 2 Balance Sheet categories (an oft-overlooked financial statement)
- 2 Profit Margin KPIs
- 5 Financial Ratio KPIs
OPEX Cost Reduction is an OVERRATED Value Proposition
For decades B2B Marketers have droned on about their “unique” OPEX cost reduction value proposition. From the buyer’s perspective, B2B Marketers have completely worn out this one-dimensional financial justification argument. Every marketer out there talks about OPEX cost reduction benefits, so customers pay little attention to that messaging because of the repetition.
The DuPont Formula, however, opens up the flood gates and completely reframes the customer conversation around 12 potential areas of financial impact. Now this is finally the financial impact conversation customers really want to engage in!
As a buy-side CFO, I was rarely if ever able to financially justify the business case for making an investment relying solely on OPEX cost reduction; I needed other financial impact areas in order to exceed the investment hurdle rate.
Your Assignment: Conduct a Sales Team Exercise Using the DuPont Formula as a Guide
In this post I will offer a few comments on the 12 financial impact areas contained in the DuPont Formula. If you are serious about leveraging the power of the DuPont Formula in future customer conversations, I recommend you form a small team of like-minded sales and marketing colleagues and work your way through each of the financial impact areas described below.
As you do this, strive to understand the KPI or financial ratio, and get creative thinking of ways to impact these financial metrics given the attributes of your solutions. As you progress make sure to keep an open mind and put yourself in the shoes of a CXO Buyer charged with building financial justification (a business case) to invest in your solutions.
Since this team activity requires a certain degree of financial acumen and may be somewhat, or completely, outside of your personal comfort zone, you may want to recruit a finance department associate at your company who is particularly good at helping non-financial people understand financial concepts and how to apply them in the field with customers.
Also, if you are a VP of Sales/Marketing, you may want to consider conducting this exercise during a sales meeting breakout session.
The Original Application of the DuPont Formula
Before we get started, here is a little history of this comprehensive financial formula. According to Wikipedia, the name comes from the DuPont Corporation that started using the formula in the 1920s. Ironically, Donaldson Brown, a DuPont sales associate assigned to market EXPLOSIVES, invented the formula in an internal efficiency report in 1912. I told you – the DuPont Formula has a very POWERFUL impact!
The original purpose of the DuPont Formula was to disaggregate “Return on Equity” or ROE (an important financial ratio for share owners) into its three components: (1) profitability as measured by “Return on Sales”, or ROS (also known as “Net Profit Margin”); (2) asset use efficiency as measured by “Asset Turnover”, or Asset Turns; and (3) Financial Leverage as measured by the inverse of the equity ratio.
To reconstruct ROE you multiple ROS times Asset Turnover (as you can see above, Net Sales cancels out), which produces “Return on Assets” or ROA. Then, in turn, ROA is multiplied by the Financial Leverage ratio (with Assets canceling out) to produce Return on Equity or ROE. It’s an elegant and powerful financial equation (as the explosives sales associate from DuPont would have attested) that contains all the levers management needs to pull to optimize financial returns for share owners.
How the DuPont Formula Actually Works
ROE is one of the only financial ratios that can be compared across different industry segments; for instance, a bank’s ROE can be compared to a retailer’s ROE or to an automotive company’s ROE. This is helpful to investors, but it doesn’t shed light on the different ways that “return” is actually generated. By disaggregating the components of the full ROE equation, the DuPont Formula enables investors to better understand the source of superior (or inferior) return.
Example: Banks vs Food Retailers vs Auto Manufacturers
According to the Reuters.com website, BANKS, on average, generate a ROS of 30% (very high compared to other industries) and an Asset Turn of .08x (very low and almost negligible because of the large amount of assets sitting on the Balance Sheet, mostly consisting loans). When ROS (30%) is multiplied by Asset Turns (.08), it produces an ROA of 2.4%. Then, to complete the math, ROA (2.4%) is multiplied by Financial Leverage of 8.3x (an extremely high-level of financial gearing) to produce an ROE product of 20%. So, how do banks generate an average ROE of 20%? The DuPont Formula tells us they do it by combining high-levels of ROS with extremely high-levels of Financial Leverage. Asset Turns are not a driver of return. How does an ROE of 20% compare with other industries? Let’s take a look at two other industries.
FOOD RETAILERS, on average, generate a relatively low ROS of 3% (versus 30% for BANKS) and a relatively high-level of Asset Turns of 1.0x (a good thing since food spoils sitting on the shelf as inventory). When ROS (3%) is multiplied by Asset Turns (1.0), it produces an ROA of 3.0%. Then, to complete the math leading to ROE, ROA (3.0%) is multiplied by Financial Leverage of 3.3x (relatively low compared to BANKS) to produce an ROE product of 10%, which is half as large as the BANKING industry. So now do you understand why so many de novo community banks have sprung up in the last 20 years?
AUTOMOTIVE MANUFACTURERS, on average, generate a middle-of-the-road ROS of 8% and a relatively average level of Asset Turns of 0.7x. When ROS (8%) is multiplied by Asset Turns (0.7), it produces an ROA of 5.6%, higher than both BANKS and FOOD RETAILERS. Then, to complete the ROE math, ROA (5.6%) is multiplied by Financial Leverage of 2.3x (relatively low compared to BANKS and FOOD RETAILERS) to produce an ROE product of 13%, right in the middle of BANKS and FOOD RETAILERS.
Companies Can “Pull” Different Financial Levers in the DuPont Formula
As you may infer from these examples, a company’s management team has several questions to answer in the development of their business strategy. Do they want to run a “Profitability Machine” (high ROS with low Asset Turns and Financial Leverage)? Or a “Distribution Powerhouse” (low ROS with high Asset Turns and average Financial Leverage)? Or a “Leveraged Powder Keg” (high ROS with negligible Asset Turns and extremely high Financial Leverage)? Or a combination of these 3 business models? These are the financial model levers embedded in the DuPont Formula that B2B Marketers need to understand customer-by-customer if they are to earn credibility and become trusted Business Advisors.
The DuPont Formula Should Guide Your Customer Conversations on Financial Impact
As I said earlier, I’m not prone to hyperbole, but I’ll make yet another exception: the DuPont Formula is a game-changer for B2B Marketers wanting to reframe and broaden the financial impact customer conversation. It opens up 12 different financial impact areas of discussion.
Now I’m not suggesting that you cover-off all 12 during a customer conversation (your solution probably can’t do that, not to mention your customer would likely nod off). But I am suggesting you open your mind about your solution’s potential financial impact and use your new insights to EXPAND the customer conversation beyond the traditional OPEX cost reduction value proposition messaging. These are the conversations that will be interesting to customers.
12 FINANCIAL IMPACT Areas
1. Revenue (Income Statement category) – Also known as Net Sales or Turnover outside N. America, Revenue growth is the lifeblood of a business or organization. Without it, an organization will eventually die; it’s that important. Revenue growth is so hard to operationally generate, let alone sustain, that it is the MOST-VALUED conversation to CXO Buyers. Revenue growth is particularly important to management and investors since performance on the top-line dictates decisions right on down the rest of the Income Statement. If Revenue is declining, cost cutting is likely to follow. Here’s a recent blog post on the importance of Revenue growth to CXO Buyers.
Here are some of the ways your solution may impact Revenue:
- Increase number of units sold
- Increase price per unit sold (or decrease discount per unit sold)
- Reduce product returns and allowances
- Increase promotional effectiveness (more sales with less promotion expense)
- Expand into new markets (including global growth), new channels, new customers
- Accelerate new product introductions and time-to-market
- Expand revenue base through acquisitions and alliances
- Up-sell and cross-sell more products and services to existing customers
- Improve revenue mix (sell more products with higher price points)
- For banks, increase interest income
- For banks, decrease interest expense
- For banks, increase noninterest income (especially fee income)
2. Cost of Sales (Income Statement category) – In most industries, this is the largest expense bucket so it is an important category of the Income Statement. Cost of Sales consists of expense categories that are directly related to the products and services that generate revenue for the company. Cost of Sales includes the materials and labor used to make the product or deliver the service. The expenses included in Cost of Sales may be itemized and subtotaled on the face of the Income Statement, or they may simply be grouped together. Sometimes, companies will not show a separate Cost of Sales category, but will include the components in Operating Expenses.
Cost of Sales is an important component of the first interim calculation of profit on the Income Statement, called Gross Profit, Gross Income, or sometimes Gross Margin. Because of the large size of Cost of Sales, Gross Profit represents an important indicator of the core financial health of the company. If the Gross Profit is a negative number, the company is in serious financial condition.
3. Operating Expenses (Income Statement category) – Sometimes referred to as OpEx, this is a diverse bucket of expenses consisting of several categories generally called “overhead”. Operating Expenses are costs not directly associated with the products and services being sold. Some of the line items that may be itemized within this bucket include “Research & Development” and “Selling, General & Administrative” or SG&A expenses. Operating Expenses are an important component of the second interim calculation of profit on the Income Statement called Operating Profit or Operating Income. Operating Profit is the most important measure of profitability resulting from the core operations of the company.
4. Assets (Balance Sheet category) – The first bucket at the top of the Balance Sheet is Assets. It’s a really big bucket containing many line items. Assets represent the economic resources of the company that have value and benefit future periods. The Asset bucket is broken down into two components: current assets and non-current assets. Current assets are resources that will turn into cash over the next 12 months. These line items are more liquid and considered to be less risky than non-current assets that are longer-term in nature. Common line items found within current assets include cash and short term investments, accounts receivable, and inventory. Non-current assets include net, property plant and equipment or PP&E, and other long term assets such as goodwill, an intangible asset that is created during acquisition accounting. Net PP&E includes all land, building, and equipment, including manufacturing plants, distribution centers, factory equipment, and office equipment including technology hardware and software.
5. Equity (Balance Sheet category) – This category is sometimes referred to as Shareholders’ Equity or Equity Capital. Equity represents the ownership interest of the stockholders in the Assets less the Liabilities of the firm; in other words the “Net” Assets. It’s what the shareholders own or have left after all liabilities are settled. When a company produces income, or profits, Equity goes up. In other words, the earnings are “retained”. Equity goes down when there are losses, or when dividends are paid, or when common shares are repurchased.
6. Gross Profit Margin – Sometimes referred to as Gross Margin. For companies with large amounts of Cost of Sales (see #2 above), the Gross Profit Margin is a measure of the success of their business model. Any change in pricing, discounting, unit volume, and the mix and cost of products sold will be reflected in this KPI. This metric takes into account all of the direct costs of the products being sold. If your customer account emphasizes Gross Profit Margin, you should explore and analyze the components of Revenue and Cost of Sales to determine if your solution has any impact on these items.
7. Operating Profit Margin – Sometimes referred to as Operating Margin or EBIT Margin (Earnings Before Interest and Taxes). The Operating Profit Margin provides a broader measure of profitability than the Gross Profit Margin since it incorporates Operating Expenses. Any changes in Operating Expenses from period to period will be reflected in this KPI. The Operating Profit Margin is the most common profitability metric used at the business-unit level of an organization. It provides an analysis of the Income Statement, but excludes the cost of financing and income taxes, which aren’t typically the responsibility of the business unit. If your customer emphasizes Operating Profit Margin, you should explore and analyze all three buckets on the Income Statement – Revenue, Cost of Sales, and Operating Expenses (see #1-3 above). This metric give you one of the broadest possibilities to align your solutions since it covers most of the Income Statement.
8. ROS (Return on Sales) – ROS is also known as Net Profit Margin, since it is calculated by dividing Net Income by Revenue. ROS is particularly useful to corporate-level management and outside investors in assessing the overall level of profitability of the organization, including all of its business units. It measures how much of each revenue dollar (or euro, yen, pound, etc.) is converted into profits. If your customer emphasizes ROS, focus your solution alignment enterprise-wide and communicate your financial impact on this metric when interfacing with corporate-level management.
9. Asset Turns (Asset Turnover) – The calculation of Asset Turns involves two financial statements. Revenue from the Income Statement divided by Assets from the Balance Sheet. When Asset Turns are rising over time, this is a very good sign that the company is producing more with less – more Revenue for every dollar (euro, yen, pound, etc.) of invested Assets. Companies that use the Asset Turn KPI also likely calculate Accounts Receivable Turns (reflecting the efficiency of collecting monies owed from customers) and Inventory Turns (reflecting the efficiency of “turning” or selling off existing levels of Inventory).
10. Return on Assets (ROA) – Calculated as ROS times Asset Turns, ROA is popular because it incorporates two financial statements into one measurement. Management must balance its focus on both earnings from the Income Statement and Assets from the Balance Sheet to achieve improvement in this KPI. If your customer chooses ROA as a key performance metric, you should review the entire Income Statement as well as the Asset bucket of the Balance Sheet to look for opportunities for your solutions. ROA provides a B2B Marketer the broadest possible opportunity to financially align solutions.
11. Financial Leverage – This ratio is calculated as Assets divided by Equity. The higher the Financial Leverage ratio, the more financial debt the company carries on its Balance Sheet. Financially Leverage is a tricky thing. At lower levels, everything works just fine when operations and the economy are doing OK. Owners of the company are able to leverage their equity investment by using debt as another funding source to produce profits. But, when Financial Leverage rises above a certain level, the equity owners may find it hard to pay off the debt. That situation spells trouble for both the debt holders and the equity owners.
12. Return on Equity (ROE) – And finally the ROE metric, which is one of the only metrics that can be compared across every industry vertical. That’s because all company owners are looking for a return on their equity investment. ROE is a popular KPI ratio used for external communication to shareholders, rather than for internal operating management purposes.
Summary
If you can sharpen your financial acumen selling skills and learn to broaden the financial conversation with customers using the DuPont Formula as a guide, I’m confident you will gain immediate credibility and Business Advisory credentials with CXO Buyers. This, in turn, is bound to lead to better customer conversations, greater trust, and more/bigger deals.
Questions:
- Do you see the value in using the DuPont Formula to guide customer conversations?
- How else could you leverage the DuPont Formula?
