Question

What will be the impact on Return on Equity (ROE) if following ratios change? Explain how changes in each ratio will affect ROE.

a. Tax burden and Interest burden go down, financial leverage increases, EBIT margin and total asset turnover remain unchanged

b. Financial leverage decreases, net profit margin and total asset turnover remain unchanged

c. EBIT margin falls, tax burden increases, interest burden remains unchanged, total asset turnover and financial leverage increase

d. Return on asset falls, net profit margin increases, financial leverage falls

Answer 1

a. Tax burden and Interest burden go down, financial leverage increases, EBIT margin and total asset turnover remain unchanged:

ROE = Tax burden × Interest burden × EBIT margin × Asset turnover × Leverage.

A lower tax burden ratio (Net income/Earnings before tax) implies that the company can keep a lower percentage of pretax profits; this implies a higher tax rate and a lower ROE. A interest burden ratio is earnings before tax to EBIT, and a lower ratio means that the company has higher borrowing costs (it gets to keep a lower pre-tax income from a given EBIT), implying a lower ROE and sustainable growth. More leverage does not always lead to higher ROE. As leverage rises, so does the interest burden. The positive effects of leverage can be offset by the higher interest payments that accompany higher levels of debt.

b. Financial leverage decreases, net profit margin and total asset turnover remain unchanged

The DuPont system can be used to break down the ROE into three components:

ROE = Profit margin x total asset turnover x financial leverage multiplier

If the net profit margin increases over time, then the firm is managing its operating and financial expenses well and the ROE should also increase over time. If the asset turnover increases, the firm is utilizing its assets efficiently, generating more sales per dollar of assets owned. Lastly, if the firm’s financial leverage increases, the firm can deploy the debt capital to magnify returns. Hence, In this case, the ROE ratio will decrease due to decrease in financial leverage.

c. EBIT margin falls, tax burden increases, interest burden remains unchanged, total asset turnover and financial leverage increase

ROE = Tax burden × Interest burden × EBIT margin × Asset turnover × Leverage.

Three components increase while only one is decreasing, with one remaining unchanged, hence overall, ROE will increase.

d. Return on asset falls, net profit margin increases, financial leverage falls

According to the the DuPont system,

ROE = Profit margin x total asset turnover x financial leverage multiplier

If the net profit margin increases over time, then the firm is managing its operating and financial expenses well and the ROE should also increase over time. But here, return on asset falls and financial leverage falls, which will ultimately decrease the ROE.