Question

Return on Equity (ROE)= Sales Margin* Asset turnover* Gearing ratio

ROE= Profit/equity

Sales Margin= Profit/Sales

Asset turnover= Sales/Assets

Gearing Ratio= Assets/Equity

This formula is important from strategy point of view as higher ROE is possible in a low profit margin business by increasing the asset turnover and by taking debt to increase the capital employed.

This Question I need it to answer ---> "good very high level summary of the ratios in this DQ. Can you provide back to me the reason that each ratio is important in strategy work and let me know which one you feel in the most important?"

Answer 1

All the component ratios of ROE calculation using Du Pont Analysis are important. However each componenet reveal some different aspects of financial performance of the company.

1. Sales Margin : This is a basic performance indicator of the firm and most universally used. We can compare among different years or different companies to asses how a company is generating net income compared to its sales.

2. Asset Turnover Ratio= Sales /Assets : It is very important to assess how the company is utilizing its assets to generate sales. Higher the ratio , the better the proformance. We can compare among different years or different companies to asses how the company is utilzing its assets to generate sales as compared to a base year or compare to other companies.

3. Gearing Ratio=Asset/Equity : It indicates how much of Equity and debt used to fund the assets. If the ratio is high that indicates large amount if debt has been used to fund the assets , so the gearing is very high. The higher gearing will reduce the cost of Capital but should bring about more income to be able to repay the finance charges.

Strategically the Gearing ratio or Equity Multiplier ( Assets /Equity) is the most important ratio in my opinion.

We can compare the ROE of different companies and periods and we may find similar ROE %, but a detailed study of the Gearing will provide the inherent risk of a business. If the Asset/Equity ratio is quite high then there is a large amount of debt that has been used to fund the assets. The company with high gearing tries to use external fund to finance assets for generating sales. But if the ROE is high only because the company has a high Gearing ratio but lower margin or asset turnover ratio, that indicates that the company has not generated any benefit of the borrowing in the form of higher income or sales. Therefore in such a case the company having same ROE but higher gearing than other companies will be more risky . On the other way , if the ROE of a company is higher than other because of higher gearing as well as higher margin and higher asset turnover, that indicates a good position as the higher net income from enhanced sales will provide higher EPS to a comparatively lower base of equity holders.

This way Gearing is a ration that reveals the structural strength /weakness of a company and in most important among the three ratio.