How does the five-way DuPont decomposition work and what does each component reveal?

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AcadiFi · Accepted Answer

The five-way DuPont (also called the extended or five-step decomposition) splits profitability into tax, interest, operating, asset-use, and leverage components: ROE = (Net Income / EBT) × (EBT / EBIT) × (EBIT / Revenue) × (Revenue / Assets) × (Assets / Equity) = Tax Burden × Interest Burden × EBIT Margin × Asset Turnover × Financial Leverage Each component isolates a specific driver: 1. **Tax Burden** (NI/EBT): what fraction of pre-tax income the firm keeps after tax. Sensitive to ETR, tax jurisdiction mix, credits, NOLs. A declining tax burden may reflect aggressive planning or higher incremental rates. 2. **Interest Burden** (EBT/EBIT): what fraction of operating profit survives interest expense. Close to 1 = low leverage or high coverage; far below 1 = heavy interest drag. Declining interest burden signals rising leverage cost. 3. **EBIT Margin** (EBIT/Revenue): pure operating profitability, free of financing and tax effects. The best cross-company comparable; reflects pricing power, cost control, mix. 4. **Asset Turnover** (Revenue/Assets): capital productivity. Retailers high, utilities low. Reveals business model. 5. **Financial Leverage** (Assets/Equity): how much the balance sheet is levered. Higher = more risk, more ROE amplification. ```mermaid flowchart TD A[ROE] --> B[Tax Burden] A --> C[Interest Burden] A --> D[EBIT Margin] A --> E[Asset Turnover] A --> F[Financial Leverage] D --> G[Operating
Quality] F --> H[Balance Sheet
Risk] ``` Analyst use: if a firm's ROE rises from 14% to 18%, decompose to see whether the driver was sustainable (margin expansion from pricing, operating leverage) or fragile (leverage increase, one-time tax benefit). Two firms with identical 16% ROE can have wildly different risk profiles — one from 18% margin × 0.9 turnover × 1.0 leverage, another from 6% margin × 1.5 turnover × 1.8 leverage.

How does the five-way DuPont decomposition work and what does each component reveal?

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