Can higher return on equity come from more leverage rather than better operations?

Specify the numerator and average equity base

Write the earnings measure and the equity claim being analyzed. Also specify whether the denominator is beginning, ending or average equity. A flow measured over a year and a balance measured on one day can answer a different question from a year’s profit divided by an appropriate average balance.

CFA Institute describes DuPont decomposition as a way to separate components of ROE. Here, a deliberately simplified three-factor identity uses net margin, asset turnover and assets divided by equity. It is a reconciliation of stipulated numbers, not evidence that raising leverage creates value.

Compare two fictional capital structures

Suppose Company A has $400 revenue, $20 net income, $200 average assets and $100 average equity, with the remaining $100 funded by liabilities. Its ROE is $20 ÷ $100 = 20%. Net margin is 5%, asset turnover is 2 and assets-to-equity is 2. Their product, 0.05 × 2 × 2, reproduces 20%.

For a separate fictional Company B, hold revenue at $400 and average assets at $200, but stipulate $50 average equity and $150 liabilities. Assume higher financing costs reduce net income to $18, with all other differences excluded. ROE becomes $18 ÷ $50 = 36%, despite lower profit. The corresponding identity is 4.5% margin × 2 turnover × 4 assets-to-equity = 36%.

Interpret the denominator instead of celebrating the ratio

In this exercise, profit did not improve and the assets did not produce more revenue. The larger equity multiplier more than offset the lower net margin. The calculation identifies a reason for the higher ratio; it does not tell you whether the liabilities are affordable, how they mature or whether the business can withstand a weaker period.

Equity can also change because of distributions, repurchases, losses or accounting adjustments. A small positive denominator can produce a large ratio. When equity is negative or near zero, the arithmetic may be computable but a familiar higher-is-better reading can become particularly misleading.

Keep a numerator-and-denominator comparison card

For a real source review, record average assets and equity, the averaging method, net income scope and any major changes during the period. Then separate changes in operating profitability, financing costs, taxes, asset use and the equity base. Preserve unusual items rather than treating them as recurring without explanation.

Compare the ratio with the underlying cash flows, obligations and business context. No single decomposition establishes default risk or the value of a share. This guide does not suggest a desirable debt level, a minimum ROE or a financing policy for any person or company.

Method, sources, and limits

Both companies and all figures are invented, with matched average-balance conventions. Arithmetic and the primary CFA source were checked on 26 October 2026. The exercise explains a possible ratio movement, not an observed corporate result, valuation model, solvency finding or recommendation to use leverage.