DuPont analysis explained: what is behind a return on equity
Return on equity, ROE, tells you how much profit a company earned for each unit of shareholders' money. It does not tell you how. Two companies can both earn 20% for entirely different reasons, and the reasons matter for how safe and how repeatable that return is. DuPont analysis splits ROE into parts so you can see which part is doing the work.
The three-step version
ROE can be written as three ratios multiplied together:
ROE = net profit margin × asset turnover × financial leverage
Each ratio answers one question:
- Net profit margin (net income ÷ revenue): how much of each unit of sales is kept as profit? This is profitability.
- Asset turnover (revenue ÷ average total assets): how much sales does each unit of assets generate? This is efficiency.
- Financial leverage (average total assets ÷ average equity): how many units of assets are financed by each unit of equity? This is how much debt is being used.
The identity holds because the denominators and numerators cancel: (net income ÷ revenue) × (revenue ÷ assets) × (assets ÷ equity) = net income ÷ equity.
A worked example
A company has revenue of 1,000, net income of 80, average total assets of 800 and average equity of 400.
- Net profit margin = 80 ÷ 1,000 = 8%
- Asset turnover = 1,000 ÷ 800 = 1.25
- Financial leverage = 800 ÷ 400 = 2.0
ROE = 8% × 1.25 × 2.0 = 20%, which matches 80 ÷ 400 directly. You can run your own figures through the DuPont calculator.
Why the split is useful
Now take a second company with the same 20% ROE. Suppose it has a net margin of 2%, asset turnover of 5 and leverage of 2. It gets there by selling a great deal at a thin margin, like a supermarket. The first company turns its assets over slowly, 1.25 times against 5, but keeps far more of each sale, 8% against 2%. They look the same on ROE and nothing like each other underneath.
Leverage deserves special attention. A company can raise ROE simply by borrowing more, without becoming any more profitable or efficient. But borrowing raises risk as well as return. A rising ROE driven by rising leverage is a very different signal from one driven by rising margins.
The five-step version
The net margin can itself be split into three pieces, giving five components:
ROE = tax burden × interest burden × EBIT margin × asset turnover × financial leverage
- Tax burden = net income ÷ pretax income. The share of pretax profit kept after tax.
- Interest burden = pretax income ÷ EBIT. The share of operating profit left after interest.
- EBIT margin = EBIT ÷ revenue. Operating profitability.
Take the same company, with EBIT of 130 and pretax income of 100. The tax burden is 80 ÷ 100 = 0.80, the interest burden is 100 ÷ 130 = 0.769, and the EBIT margin is 130 ÷ 1,000 = 13%. Multiply: 0.80 × 0.769 × 0.13 × 1.25 × 2.0 = 20%. The same answer, but now you can see where the profit goes: tax takes a fifth of pretax profit, and interest takes almost a quarter of operating profit.
Using it in practice
DuPont analysis is most useful for comparisons, in two ways:
- Over time, for one company. Which component changed when ROE moved? A rise in ROE with falling margin and rising leverage is a warning.
- Across companies in the same industry. Which has the better margin, the faster turnover, the heavier debt?
Always use the same basis. Average balances are standard, but if a question gives only ending balances, use them and say so.
Mistakes to avoid
- Using the wrong base. Average assets and average equity match the income earned over the period; a year-end snapshot does not.
- Mixing up leverage and the debt ratio. Financial leverage here is assets ÷ equity, which is always at least 1.
- Interpreting a high ROE as good news without checking its source.
- Forgetting the five-step identity must multiply back to the three-step ROE; it is a useful check on your arithmetic.
Where this is tested
DuPont analysis is a staple of financial statement analysis and comes back in equity valuation. The learning outcomes below set out the exact decompositions you are expected to apply.