Skip to content
Get started
Get startedLog in

Financial ratio analysis and DuPont for the CFA® Program Level I

Financial ratios assess liquidity, solvency, activity and profitability. Three- and five-step DuPont analysis explain ROE, with formulas, interpretation traps and an original worked example.

CFA® Program Level I guideBy High Performer CertsPublished 8 min read

Key facts

  • Liquidity concerns short-term payments; solvency concerns longer-term financial obligations.
  • Activity ratios measure asset use; profitability ratios relate earnings to revenue, assets or equity.
  • Three-step DuPont analysis expresses ROE as net profit margin × total asset turnover × equity multiplier.
  • Five-step DuPont analysis splits net margin into tax burden × interest burden × EBIT margin.
  • Higher ROE can reflect lower book equity rather than stronger operations; consistent definitions are essential.

Financial ratios describe liquidity, solvency, asset use and profitability; DuPont analysis explains the components of return on equity. The three-step version separates net margin, asset turnover and leverage. The five-step version further separates operating profitability from interest and tax effects. Interpret the components together, using consistent definitions and comparable businesses. (ACCA, ratio interpretation (secondary source)) (AAII, DuPont analysis (secondary source))

This guide supports study for the CFA® Program Level I, run by CFA Institute. (CFA Institute, Level I exam) Our questions complement CFA Institute's own curriculum; they do not replace it. See the course page and our time value of money guide for discounting future cash flows.

Which balances and definitions should you use?

Income statements cover a period; balance sheets describe a date. Match annual income or sales with average assets or equity for that year. Here, averages mean opening plus closing balance, divided by two. Use the same average throughout each DuPont calculation. Liquidity and debt ratios below use closing balances. (SEC, financial statements) (AAII, DuPont analysis (secondary source))

Define debt before calculating: we use interest-bearing borrowings and book equity. Total liabilities also include obligations such as trade payables, so liabilities-to-equity answers a different question. Check the numerator rather than relying on a ratio's label. (Damodaran, financial ratios (secondary source)) (SEC, financial statements)

What do liquidity ratios tell you?

Liquidity concerns meeting short-term obligations. The current ratio includes all current assets. Our quick ratio includes cash, liquid short-term investments and collectible trade receivables; inventory and prepayments are excluded. (ACCA, ratio interpretation (secondary source)) (BDC, quick ratio (secondary source))

Current ratio=Current assetsCurrent liabilities\text{Current ratio}=\frac{\text{Current assets}}{\text{Current liabilities}}Quick ratio=Cash+Liquid investments+ReceivablesCurrent liabilities\text{Quick ratio}=\frac{\text{Cash}+\text{Liquid investments}+\text{Receivables}}{\text{Current liabilities}}

A strong current ratio can conceal slow-moving inventory. Even quick assets may not become cash before bills fall due. Compare collection timing, payment commitments and operating cash flows; there is no universal healthy ratio across industries. (ACCA, ratio interpretation (secondary source)) (SEC, financial statements)

How do solvency ratios measure financing risk?

Solvency analysis considers longer-term financial obligations. Debt-to-equity and debt-to-assets describe the financing structure; interest coverage compares earnings before interest and tax (EBIT) with interest expense. Higher borrowing adds repayment and interest commitments. (Damodaran, financial ratios (secondary source)) (CFI, debt to assets (secondary source)) (ACCA, ratio interpretation (secondary source))

Debt/equity=DebtEquity,Debt/assets=DebtAssets\text{Debt/equity}=\frac{\text{Debt}}{\text{Equity}},\qquad\text{Debt/assets}=\frac{\text{Debt}}{\text{Assets}}Interest coverage=EBITInterest expense\text{Interest coverage}=\frac{\mathrm{EBIT}}{\text{Interest expense}}

EBIT is an accounting earnings measure. Coverage therefore does not establish that cash is available for interest or principal repayments. Read it alongside the cash-flow statement and debt maturities. (SEC, financial statements)

What do activity ratios measure?

Activity ratios relate sales or costs to assets employed. Inventory turnover divides cost of sales by average inventory. Receivables turnover uses credit sales; disclose any substitution of total revenue. Total asset turnover measures revenue generated per unit of average assets. (SEC, financial statements) (ACCA, ratio interpretation (secondary source)) (AAII, DuPont analysis (secondary source))

Inventory turnover=Cost of salesAverage inventory\text{Inventory turnover}=\frac{\text{Cost of sales}}{\text{Average inventory}}Receivables turnover=Credit salesAverage receivables,Asset turnover=RevenueAverage assets\text{Receivables turnover}=\frac{\text{Credit sales}}{\text{Average receivables}},\qquad\text{Asset turnover}=\frac{\text{Revenue}}{\text{Average assets}}

With annual figures and a 365-day convention, inventory days equal 365 divided by inventory turnover; receivables days use receivables turnover. Faster turnover can release working capital, but insufficient stock can impair customer service. Compare changes with the business model. (ACCA, ratio interpretation (secondary source))

How do profitability ratios differ?

Gross margin divides revenue less cost of sales by revenue. Operating margin divides operating profit by revenue; net margin uses profit after interest and tax. Margins locate changes in profitability at different stages of the income statement. (ACCA, ratio interpretation (secondary source)) (SEC, financial statements)

Net margin=Net incomeRevenue,ROE=Net incomeAverage equity\text{Net margin}=\frac{\text{Net income}}{\text{Revenue}},\qquad\mathrm{ROE}=\frac{\text{Net income}}{\text{Average equity}}

Return on assets (ROA) here means net income divided by average assets. Other ROA conventions adjust the earnings numerator for financing costs, so compare like with like. Our example has only ordinary equity, with all net income attributable to those shareholders. ROE is an accounting return, not a share-price return. (Damodaran, financial ratios (secondary source))

How does three-step DuPont analysis work?

Let NI mean net income, S revenue, A average total assets and E average equity. Multiplying the following fractions cancels revenue and assets, leaving NI/E: (AAII, DuPont analysis (secondary source))

ROE=NIS⏟Net margin×SA⏟Asset turnover×AE⏟Equity multiplier\mathrm{ROE}=\underbrace{\frac{NI}{S}}_{\text{Net margin}}\times\underbrace{\frac{S}{A}}_{\text{Asset turnover}}\times\underbrace{\frac{A}{E}}_{\text{Equity multiplier}}

The equity multiplier measures average assets relative to average equity. Holding net margin and asset turnover constant at positive values, a higher multiplier raises ROE. It reflects financing by all liabilities, not just interest-bearing debt: the balance-sheet identity is assets equals liabilities plus equity. (AAII, DuPont analysis (secondary source)) (SEC, financial statements)

What does five-step DuPont add?

Let EBT mean earnings before tax. Split net margin into tax burden, interest burden and EBIT margin: (AAII, DuPont analysis (secondary source))

ROE=NIEBT⏟Tax burden×EBTEBIT⏟Interest burden×EBITS⏟EBIT margin×SA×AE\mathrm{ROE}=\underbrace{\frac{NI}{EBT}}_{\text{Tax burden}}\times\underbrace{\frac{EBT}{EBIT}}_{\text{Interest burden}}\times\underbrace{\frac{EBIT}{S}}_{\text{EBIT margin}}\times\frac{S}{A}\times\frac{A}{E}

Despite their names, higher burden factors generally mean less profit lost to tax or interest when earnings are positive. Tax burden is the proportion of pretax profit retained. Interest burden measures profit retained after interest where EBT equals EBIT less interest expense. (AAII, DuPont analysis (secondary source))

The algebra requires non-zero denominators. EBIT margin represents operating margin in our example because there is no non-operating income. Where other items intervene, inspect the reconciliation before attributing every movement to financing or operations. (ACCA, ratio interpretation (secondary source))

Worked example: reconcile the ratios

These are invented annual figures, all in £000. All sales are on credit. EBIT is operating profit; interest expense is the only item between EBIT and EBT. The tax charge is an illustrative assumption.

Illustrative company inputs (£000)
ItemAmount or opening → closing
Revenue / cost of sales1,440 / 864
EBIT / interest expense / tax expense216 / 36 / 45
Total assets1,000 → 1,160
Ordinary equity400 → 464
Inventory120 → 168
Trade receivables160 → 200
Closing cash / liquid investments / prepayments72 / 24 / 16
Closing current liabilities / interest-bearing debt240 / 348

Current assets comprise only the listed items: 72 + 24 + 200 + 168 + 16 = 480. EBT is 216 − 36 = 180; net income is 180 − 45 = 135. Average assets, equity, inventory and receivables are respectively 1,080, 432, 144 and 180.

  • Liquidity: current ratio = 480/240 = 2.00; quick ratio = (72 + 24 + 200)/240 ≈ 1.23.
  • Solvency: debt/equity = 348/464 = 0.75; debt/assets = 348/1,160 = 30%; interest coverage = 216/36 = 6 times.
  • Activity: inventory turnover = 864/144 = 6 times; receivables turnover = 1,440/180 = 8 times; asset turnover = 1,440/1,080 ≈ 1.3333 times. Inventory days ≈ 60.83; receivables days ≈ 45.63.
  • Profitability: gross margin = 40%; EBIT margin = 15%; net margin = 9.375%; ROA = 12.5%; ROE = 135/432 = 31.25%.

Keep full precision until the final answer. The two decompositions reconcile exactly:

ROE3=1351440×14401080×1080432=31.25%\mathrm{ROE}_{3}=\frac{135}{1440}\times\frac{1440}{1080}\times\frac{1080}{432}=31.25\%ROE5=135180×180216×2161440×14401080×1080432=31.25%\mathrm{ROE}_{5}=\frac{135}{180}\times\frac{180}{216}\times\frac{216}{1440}\times\frac{1440}{1080}\times\frac{1080}{432}=31.25\%

Tax burden is 0.75, meaning a 25% effective tax charge; interest burden is approximately 0.8333. These are retained-profit factors. The latter differs from interest coverage of 6 times, which divides EBIT by interest expense itself.

ROE of 31.25% combines ROA of 12.5% with an equity multiplier of 2.5. The difference reflects the financing structure, not an extra operating margin. The gap between current and quick ratios comes from inventory and prepayments: those assets contribute to current-asset cover but are excluded from quick-asset cover.

Which interpretation traps should you check?

Frequently asked questions

How do the current and quick ratios differ?

Both divide assets by current liabilities. The current ratio includes all current assets; the quick ratio here includes cash, liquid short-term investments and collectible receivables, excluding inventory and prepayments.

Why use average assets and equity?

Annual income and revenue cover a period, while balance-sheet amounts describe a date. Opening and closing averages align the denominator more closely with that period. Use the same averages throughout DuPont.

What is the difference between three-step and five-step DuPont?

Three-step DuPont multiplies net margin, asset turnover and the equity multiplier. Five-step DuPont splits net margin into tax burden, interest burden and EBIT margin. Both give 31.25% ROE in the worked example.

Is the interest burden factor the same as interest coverage?

No. Interest burden is EBT divided by EBIT. Interest coverage is EBIT divided by interest expense. The example gives approximately 0.8333 and 6 times respectively.

Does higher ROE always mean stronger operating performance?

No. A reduced equity base can raise ROE without stronger operations. Check margins, turnover and financing together; average equity close to zero or below zero makes interpretation particularly difficult.

Sources

  1. US Securities and Exchange Commission: Beginners' Guide to Financial Statement — statements, inventory turnover and operating margin (4 February 2007). Accessed 29 October 2026.
  2. Association of Chartered Certified Accountants (technical article, secondary source): Financial statements interpretation — profitability, liquidity, activity and gearing. Accessed 29 October 2026.
  3. Business Development Bank of Canada (financial education, secondary source): Quick ratio calculator — eligible quick assets and current liabilities. Accessed 29 October 2026.
  4. Aswath Damodaran, NYU Stern School of Business (academic primer, secondary source): A Primer on Financial Statements — profitability, book equity, leverage and interest coverage. Accessed 29 October 2026.
  5. Corporate Finance Institute (financial education, secondary source): Debt to Asset Ratio — interest-bearing debt divided by total assets (30 March 2020). Accessed 29 October 2026.
  6. American Association of Individual Investors (analytical article, secondary source): Deconstructing ROE: DuPont Analysis — three-step and five-step decompositions. Accessed 29 October 2026.
  7. CFA Institute: CFA Program Level I exam: format and topic weights. Accessed 26 October 2026.

High Performer Certs is an independent study platform. It is not affiliated with, endorsed by, or sponsored by CFA Institute or the Global Association of Risk Professionals (GARP). We are not a CFA Institute Prep Provider and not a GARP Exam Preparation Provider. CFA Institute does not endorse, promote, review or warrant the accuracy or quality of our products and services. GARP does not endorse, promote, review or warrant the accuracy of our products or services. All questions and explanations are our own original material and contain no CFA Institute or GARP exam, curriculum or practice questions. CFA®, Chartered Financial Analyst®, CIPM® and GIPS® are registered trademarks owned by CFA Institute. FRM® and GARP® are trademarks owned by the Global Association of Risk Professionals.

Cookie settings

Choose which optional tools we may use. We store your choice in your browser for 12 months (local storage, “hp.consent”). Details: privacy policy.

Strictly necessaryAlways on

Remembering this choice and, in the app, keeping you signed in. No tracking.

Statistics without cookiesAlways on

Our own visit counter and Vercel Web Analytics. Nothing is stored on your device, no IP addresses are kept and you cannot be recognised on another day.

Heatmaps and session recordings that show how visitors use our public pages. Form fields and personal details are masked. Sets the cookies _clck (1 year) and _clsk (1 day). Microsoft processes the data as an independent controller and may transfer it to the USA. Never used in the app or on sign-in pages.