Charta is on Google Play: practise on the go. Get the app
Charta

Break return on equity into its parts with DuPont analysis

CFA® Level I · Financial Statement Analysis · Financial Analysis Techniques · FSA.5.b

The idea

The three-part decomposition expresses return on equity as net profit margin times asset turnover times the equity multiplier, separating profitability, efficiency and leverage. The five-part version splits the margin further into a tax burden, an interest burden and an operating margin, which isolates operating performance from financing and tax. The value of the decomposition is diagnostic: two companies with identical return on equity can arrive there by entirely different routes, and a return driven by leverage is a different proposition from one driven by margin.

Formulas

DuPont decomposition of return on equity

ROE = (net income ÷ revenue) × (revenue ÷ average assets) × (average assets ÷ average equity)

net income
profit after tax
revenue
sales for the period
average assets
opening and closing total assets averaged
average equity
opening and closing shareholders' equity averaged

Profitability, then efficiency, then leverage. The middle terms cancel, so it is the same ROE — the point is to say which of the three moved. A rise driven by the last term is a rise bought with debt.

A practice question

From the question bank, with the reason each wrong option is wrong.

What are the three components of the standard DuPont decomposition?

  1. Net profit margin, asset turnover and the equity multiplier — correct
  2. Gross margin, operating margin and net marginWhy not: Three profitability measures, all describing the same dimension. The decomposition needs efficiency and leverage as well, and these three multiply to nothing meaningful.
  3. Current ratio, quick ratio and cash ratioWhy not: Three liquidity measures, and again all of one kind. None of them feeds return on equity.

Profitability, efficiency and leverage multiply to give return on equity, which is what makes the source of a return visible.

A harder one

Two companies report a return on equity of 18%. One has an equity multiplier of 1.2 and the other 3.5. What does this indicate?

  1. The two are equally attractive, since the returns are identicalWhy not: The returns are identical and the risks are not. The levered company's fixed obligations do not fall when earnings do.
  2. The second gets its return through leverage — correct
  3. The first must have higher asset turnoverWhy not: Higher margin would do just as well — the decomposition has three terms and the first company could lead on either of the other two.

The same headline result therefore carries far more financial risk. Identical returns from different sources are not identical propositions: the levered company's return will deteriorate faster in a downturn, and its fixed obligations do not fall with earnings.

The hardest tier

What does the five-part decomposition add over the three-part version?

  1. It includes the dividend payout ratio as wellWhy not: Payout belongs to the sustainable growth calculation, which builds on return on equity rather than decomposing it.
  2. It adjusts for inventory accounting differencesWhy not: No version of DuPont adjusts for accounting policy. That work has to be done on the statements before any ratio is computed.
  3. It splits net margin into tax, interest and operating — correct

Net margin mixes three quite separate things. Separating them shows whether a margin difference between companies is operational, a consequence of leverage, or simply where they pay tax.

In the app: 12 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.

Take the free diagnostic →

More in Financial Analysis Techniques