Under the 3-step DuPont Analysis framework, how is Return on Equity (ROE) decomposed, and what does it reveal if a company's ROE rises from 15% to 25% purely due to an increase in its Equity Multiplier (Financial Leverage)?

[ A ]ROE = Cash Balance * Inventory Turnover * Dividend Yield; the improvement proves the company has eliminated all business risks.

[ B ]ROE = Gross Profit * Debt Ratio * Tax Rate; the improvement indicates the company is tax-exempt.

[ C ]DuPont analysis decomposes ROE into physical gold bullion weights and employee age distributions.

[ D ]ROE = Net Profit Margin * Asset Turnover * Equity Multiplier (Assets/Equity); if ROE rises purely due to the Equity Multiplier, the improvement is driven by higher debt leverage rather than operational efficiency, increasing financial risk.[ CORRECT ]

Takeaway

Option D is correct: ROE = Net Profit Margin * Asset Turnover * Equity Multiplier (Assets/Equity); if ROE rises purely due to the Equity Multiplier, the improvement is driven by higher debt leverage rather than operational efficiency, increasing financial risk.

Derivation

DuPont Analysis decomposes Return on Equity into three operational drivers: ROE = (PAT / Sales) * (Sales / Assets) * (Assets / Equity) = Net Profit Margin (profitability) * Asset Turnover (operational efficiency) * Equity Multiplier (financial leverage). If ROE expands solely because the Equity Multiplier increased while margins and asset turnover remained flat, the firm simply took on more debt to boost ROE. While optically attractive, debt-driven ROE increases financial solvency risk during economic downturns. This tests diagnostic ratio analysis. The common trap is praising high ROE without checking debt leverage.

Why the others fail

A — ROE = Cash Balance * Inventory Turnover * Dividend Yield; the improvement proves the company has eliminated all business risks.

DuPont analysis decomposes ROE into margins, turnover, and leverage, not cash balances, inventory, and dividend yields.

B — ROE = Gross Profit * Debt Ratio * Tax Rate; the improvement indicates the company is tax-exempt.

The three components of 3-step DuPont are Net Profit Margin, Asset Turnover, and Equity Multiplier, not gross profit and tax rates.

C — DuPont analysis decomposes ROE into physical gold bullion weights and employee age distributions.

DuPont analysis is a financial ratio decomposition model and has no connection to physical gold weights or employee demographics.