Final answer:
The DuPont decomposition of ROE is a financial analysis tool that breaks down the ROE ratio into its components to understand the drivers of a company's profitability. The 5-stage decomposition method allows detailed analysis of profit margin, asset turnover ratio, and financial leverage. Each stage represents a different aspect of financial performance.
Step-by-step explanation:
The DuPont decomposition of Return on Equity (ROE) is a widely used financial analysis tool that breaks down the ROE ratio into its components to gain insights into the drivers of a company's profitability. The 5-stage DuPont decomposition method allows for a more detailed analysis of how a company's ROE is influenced by its profit margin, asset turnover ratio, and financial leverage.
The formula for the 5-stage DuPont decomposition of ROE is: ROE = (Net Income / Sales) * (Sales / Total Assets) * (Total Assets / Equity) * (Equity / Equity) * (Equity / Total Assets). Each stage of the decomposition represents a different aspect of a company's financial performance.
For example, the profit margin stage measures how efficiently a company generates profit from its sales, while the asset turnover ratio stage indicates the company's ability to generate revenue from its assets. The financial leverage stage quantifies the impact of debts and equity in contributing to the company's return on equity.