DuPont analysis: three-step and five-step ROE

What is DuPont analysis?

It is a way of splitting ROE into the pieces that cause it. DuPont analysis (the return on equity decomposition ) shows whether ROE comes from earning a good margin, using assets efficiently, borrowing, or paying little tax. It was developed at DuPont, and databases publish the five-step version.

It is useful for two jobs: explaining why a company’s ROE changed over time, and explaining why two companies have different ROEs.

How does the three-step version work?

Start with ROE as net income over average equity, then multiply and divide by revenue and by assets. Net income over average assets is the return on assets (ROA), so ROE becomes ROA times leverage.

$$\text{ROE} = \text{ROA} \times \frac{\text{average total assets}}{\text{average total equity}}$$

$$\text{ROE} = \frac{\text{NI}}{\text{revenue}} \times \frac{\text{revenue}}{\text{average assets}} \times \frac{\text{average assets}}{\text{average equity}}$$

The three terms are the net profit margin (profitability), total asset turnover (efficiency) and financial leverage (the use of debt). With no liabilities, leverage is 1.0 and ROE equals ROA. Leverage raises ROE only while the company earns more on the borrowed money than it pays for it.

How does the five-step version work?

It splits the net margin into three pieces: tax, interest and operating profit, using earnings before tax (EBT) as the middle step.

$$\text{Tax burden} = \frac{\text{NI}}{\text{EBT}} = 1 - \text{effective tax rate}$$

$$\text{Interest burden} = \frac{\text{EBT}}{\text{EBIT}}$$

The tax burden is the share of pretax profit the company keeps. The interest burden is the share of EBIT left after interest. Both are below 1 and higher is better. The EBIT margin (EBIT ÷ revenue) measures operating profitability.

$$\text{ROE} = \frac{\text{NI}}{\text{EBT}} \times \frac{\text{EBT}}{\text{EBIT}} \times \frac{\text{EBIT}}{\text{revenue}} \times \frac{\text{revenue}}{\text{avg. assets}} \times \frac{\text{avg. assets}}{\text{avg. equity}}$$

ROEnet income ÷ average equity

• ROA net income ÷ average assets
  • Net profit margin Memorize NI ÷ revenue
    • Tax burden Memorize NI ÷ EBT
    • Interest burden Memorize EBT ÷ EBIT
    • EBIT margin Memorize EBIT ÷ revenue
  • Total asset turnover Memorize revenue ÷ average assets
• Financial leverage Memorize average assets ÷ average equity

Which component explains a change in ROE?

Compare the components year by year and find the branch that moved. Calder Foods (USD m) shows why it matters.

	Year 1	Year 2
Revenue	1,500	1,800
EBIT	150	180
EBT	120	126
Net income	90	94.5
Average assets	1,000	1,200
Average equity	500	480

How do you read ratios together?

Integrated ratio analysis means no single ratio settles the question. Use the DuPont tree as the frame and the other ratios as evidence.

• ROE from rising margin and turnover is higher quality than ROE from rising leverage.
• Falling margins with rising turnover can be a deliberate price-cutting strategy: check the net effect on ROA.
• Rising revenue with rising receivables days can signal loose credit that props up sales.
• A high-margin, low-turnover model (luxury goods) and a low-margin, high-turnover model (discount retail) can reach the same ROE. Compare each company’s components with peers to see its model.

Exam tip When a question gives two years of components, find the one that changed most in percentage terms, then check whether it is an operating or a financing branch.

Go deeper Why the five-step product equals the three-step product

Write the net margin as NI ÷ revenue. Multiply and divide by EBT and by EBIT: NI ÷ revenue = (NI ÷ EBT) × (EBT ÷ EBIT) × (EBIT ÷ revenue). Nothing has been added, only multiplied by 1 twice. Swap that in and the five terms telescope back to NI ÷ average equity. Some analysts use operating income rather than EBIT in the second and third terms. That is fine if it is done consistently, but the second term then also captures non-operating items.

Go deeper Leverage cuts both ways

Extra debt lifts ROE only if the return on assets exceeds the after-tax cost of the borrowing. If ROA falls below the cost of debt, adding leverage lowers ROE, and the extra interest also shrinks the interest burden. This is the same idea as the leveraged return formula in the rates and returns lessons, applied to the company’s own equity.