Updated for the 2026-2027 CFA® Level I curriculum.
Return on equity tells you how much profit a company generates per dollar of shareholder equity. On its own, ROE does not explain why it is high or low. DuPont analysis breaks ROE into component ratios so you can see whether profitability, efficiency, or leverage is driving the result. CFA Level I tests both the calculation and the interpretation of what changes in these components mean for a company's financial position.
Quick Answer
DuPont analysis decomposes return on equity into multiplicative components that explain what drives a company's ROE. The 3-step model splits ROE into net profit margin, total asset turnover, and financial leverage. The 5-step model further divides net profit margin into tax burden, interest burden, and EBIT margin. CFA Level I requires you to calculate these components and interpret what a change in any one of them means for ROE.
Key Takeaways
DuPont analysis breaks return on equity (ROE) into component ratios that multiply back to total ROE.
The 3-step DuPont equation is Net profit margin × Total asset turnover × Financial leverage.
The 5-step DuPont equation splits net profit margin into tax burden, interest burden, and EBIT margin.
A rising ROE driven by margin or efficiency gains signals stronger operating performance than one driven by leverage alone.
Because the components multiply, you cannot simply add percentage point changes to find the net effect on ROE.
Average balance sheet figures, not period-end figures, are the standard inputs for turnover and leverage ratios.
What You Need to Know for CFA Level I
The LOS asks you to demonstrate the DuPont decomposition and to calculate and interpret the effect of changes in its components, not just memorize the formula.
This page owns the decomposition of ROE into its 3-step and 5-step components.
You need to calculate each component ratio and confirm they multiply back to total ROE.
You need to identify which component (margin, efficiency, or leverage) explains a change in ROE between two periods.
This note does not cover how ROE relates to other ratios in a broader ratio framework. That belongs to Relationships Among Ratios and Company Evaluation.
The main trap is treating a leverage-driven ROE increase as automatically positive without weighing the added financial risk.
What Is DuPont Analysis?
DuPont analysis rewrites the ROE formula as a product of ratios instead of a single number. Each ratio isolates one driver of shareholder return: how profitable sales are, how efficiently assets generate revenue, and how much debt financing magnifies equity returns. Because the components multiply together algebraically back to ROE, you can trace a change in overall ROE to a specific operating or financing cause.
The Three-Step DuPont Model
where:
Net Income: profit available to common shareholders,
Revenue: total sales for the period,
Average Total Assets: , and
Average total equity: .
Notice that Revenue and Total Assets cancel out algebraically, leaving , the standard ROE formula. The three-step model shows the ratios that combine to produce it.
The Five-Step DuPont Model
This model takes net profit margin apart to separate tax effects, financing cost, and core operating profitability.
where:
Net Income: profit after tax and interest,
EBT: earnings before tax,
EBIT: earnings before interest and tax,
Tax Burden: , the portion of pretax profit kept after tax,
Interest burden: , the portion of operating profit remaining after interest expense, and
EBIT margin: , core operating profitability.
Interpreting Changes in ROE Components
A change in ROE is only useful once you trace it to a component. Rising net profit margin or asset turnover usually reflects operating improvement, such as better cost control, pricing power, or more efficient use of assets. Holding the other DuPont components constant, rising leverage increases ROE when the earnings components are positive, because equity is a smaller base relative to assets. Analysts treat margin- and turnover-driven ROE growth as more sustainable than leverage-driven growth, because higher leverage also raises financial risk and the cost of financial distress.
Working Example
Setup
Harbor Supply Co. reports the following figures for two consecutive years (in millions):
Item | Year 1 | Year 2 |
|---|---|---|
Net income | $40 | $54 |
Revenue | $800 | $900 |
Average total assets | $500 | $540 |
Average total equity | $200 | $200 |
Step 1: Calculate the 3-step components.
Year 1:
Year 2:
Step 2: Interpret the change.
ROE rose from 20.0% to 27.0%, a 7 percentage point increase. All three component values increased: profit margin grew by one percentage point, turnover edged up, and leverage rose as the company carried more assets on an unchanged equity base.
Plain-English interpretation: Harbor Supply's ROE gain came from a mix of better profitability and more leverage, not efficiency alone. An analyst should check whether the added leverage, assets grew from $500 million to $540 million on the same equity base, increases financial risk, since part of the ROE improvement is not purely operational.
Step 3: Extend to the 5-step model for Year 2.
Assume Year 2 EBIT is $80 million and interest expense is $8 million, giving EBT of $72 million. With net income of $54 million, income tax expense is $18 million. Cash taxes paid need not equal that expense.
This confirms the same ROE and shows that Harbor Supply keeps 75% of pretax income after tax, 90% of operating profit after interest, and earns an 8.9% operating margin on sales.
Common Exam Traps
Treating leverage-driven ROE growth as good news
Rising financial leverage raises ROE mechanically. Check whether margin and turnover also improved before concluding operating performance strengthened.
Mixing up tax burden and interest burden
Tax burden is net income divided by EBT. Interest burden is EBT divided by EBIT. Reversing these is a common slip under time pressure.
Using period-end balances instead of averages
Turnover and leverage ratios use average total assets and average equity. Using year-end figures alone can distort results, especially after a large acquisition or share buyback.
Adding instead of multiplying component changes
Because ROE is a product of ratios, you cannot sum percentage point changes in margin and turnover to find the ROE change. Recalculate the full product for each period and compare.
Confusing this note with ratio relationship analysis
DuPont analysis decomposes ROE itself. It does not cover how ROE relates to the full set of ratios, which is addressed in Relationships Among Ratios and Company Evaluation.
Practice Question
Ellerton Manufacturing reports the following DuPont component changes from Year 1 to Year 2. Financial leverage stayed constant at 2.0× in both years.
Component | Year 1 | Year 2 |
|---|---|---|
Net profit margin | 8.0% | 6.0% |
Total asset turnover | 1.5x | 1.8x |
What happened to Ellerton's ROE from Year 1 to Year 2?
ROE increased because asset turnover improved.
ROE decreased because the decline in net profit margin outweighed the gain in asset turnover.
ROE stayed the same because the two component changes offset each other.
Correct Answer: Option B
ROE fell by 2.4 percentage points. The margin decline had a larger proportional effect than the turnover improvement, so overall ROE decreased.
Option A: Focuses only on the turnover improvement and ignores that the margin decline was proportionally larger, so ROE actually fell rather than rose.
Option C: Assumes the two changes offset without recalculating both years. Because ROE components multiply rather than add, the exact values must be compared, and here they do not offset.
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FAQs About DuPont Analysis of Return on Equity
What is the difference between the 3-step and 5-step DuPont equations?
The 3-step model splits ROE into net profit margin, asset turnover, and financial leverage. The 5-step model breaks net profit margin further into tax burden, interest burden, and EBIT margin, giving a more detailed view of operating and financing effects.
Does a higher ROE always mean better performance?
Not necessarily. A higher ROE driven by more debt raises returns mechanically, even without any improvement in profitability or efficiency. Check which component changed before judging the result.
How do you calculate the 5-step DuPont analysis?
Multiply tax burden , interest burden , EBIT margin , total asset turnover , and financial leverage . The product equals ROE.
Should DuPont analysis use average or ending balance sheet figures?
Standard practice uses average total assets and average total equity for the turnover and leverage components, since these ratios compare a flow, such as income or revenue, to a balance that changes during the year.
Is DuPont analysis the same as general ratio analysis?
No. DuPont analysis specifically decomposes ROE into its multiplicative drivers. Broader ratio analysis, including how ratios relate across liquidity, solvency, and profitability categories, is covered separately.