Question

As you can determine from the attached financial statements (balances are at year end), the return on equity (ROE) declined significantly from 2013 to 2015. Decompose ROE into the five component ratios (for each year) and offer a thoughtful explanation for the decline. (When calculating ratios that use balance sheet items, please use the year-end numbers. Do not use averages. For example, when calculating a ratio that uses total assets, use the balance sheet number provided for that year. Do not use the average [(beginning + end)/2].

2013 2014 2015
Revenue 5400 7760 8123
Cost of goods Sold 4170 6050 6579
Selling, Gen. Admin
expenses 590 931 1123
Depreciation 50 50 75
Operating Income 590 729 346
Interest 28 49 56
Earnings before Tax 562 680 290
Taxes 174 211 90
Net Income 388 469 200
Cash 50 60 30
Accts. Receivable 720 730 690
Inventory 430 590 600
Net Property, Plant &
Equip. 2500 3060 3320
Total Assets 3700 4440 4640
Current Liabilities 1110 1550 1650
Long Term Debt 400 700 800
Total Liabilities 1510 2250 2450
Stock equity 2190 2190 2190
Total Liabilities and equity 3700 4440 4640

Answer 1

Financial Statement Data	2013	2014	2015
Sales	5,400.0	7,760.0	8,123.0
EBIT	590.0	729.0	346.0
Interest Expense (Non-0perating)	28.0	49.0	56.0
Tax Expense	174.0	211.0	90.0
Net Income (Income for Primary EPS)	388.0	469.0	200.0
Assets	3,700.0	4,440.0	4,640.0
Equity	2,190.0	2,190.0	2,190.0

	2013	2014	2015
Pre-Interest Pretax Margin (EBIT ÷ Sales)	10.9%	9.4%	4.3%
Asset Turnover (Sales ÷ Average Assets)	1.46	1.75	1.75
Interest Burden [(EBIT - Interest Expense) ÷ EBIT]	95.3%	93.3%	83.8%
Tax Efficiency [1 - (Tax Expense ÷ (EBIT - Interest Expense))]	69.0%	69.0%	69.0%
Equity Multiplier (Average Assets ÷ Average Equity)	1.69	2.03	2.12
Return on Equity	17.7%	21.4%	9.1%

1. The Pre Interest Pre Tax Margin has declined from 10.9% in 2013 to 4.3% in 2015. Looking at the Income statement, COGs has increase from 77% in 2013 to 81% of sales in 2015. Selling and Admin expenses have increase from 11% to 14% of sales. This has contributed greatly to decline in EBIT % to sales even though sales have increased during these years.

2. Asset turnover indicates the amount of sales a company generates for each dollar of assets . The ratio has increased from 1.46 to 1.75 in 2014 but it has remained same in 2015 despite increase in assets and sales. This indicates there was no increase in amount of sales generated for each dollar of assets.

3. Interest burden ratio or Interest coverage ratio is used to determine how easy it is for the company to pay its interest expense. Higher the ratio, higher is the companies paying capacity. The comapny's Interest burden ratio has come down as EBIT of the company has decreased from 2013 to 2015, while interest expense is increasing in absolute terms.

4. Tax Efficiency ratio has no change. It has not impacted the decrease in ROE

5. Equity Multiplier is ratio calculated to measure company's financila leverage. Higher equity multiplier means company has more debt than equity to finance its assets. The equity mulitiplier has increase from 1.69 to 2.12 from 2013 to 2015, which means company has borrowed more debt which results in higher interest expense leading to lower Net income and hence decrease in overall ROE of the company.