Question

1, Describe whether you want a high value or a low value for each ratio, independent of the other ratios.

– Return on equity:

– Profit margin ratio:

– Asset turnover ratio:

– Financial leverage ratio:

2, The profit margin ratio is the only ratio that makes up ROE that can be negative (except in relatively rare cases). Describe how the interpretation of the Asset Turnover Ratio and the Financial Leverage Ratio change based on whether the Profit Margin Ratio is positive or negative.

Answer 1

1 (a) - Return on Equity = Net Income or Profit after tax / Shareholder's Equity

As aim of business is to maximise return so it should be higher and positive because Net income is in numerator. But if it is in negative then its better to keep it lower.

(b) Profit margin ratio = Net Profits or Profit after tax / Sales

To maximise profit/return, it also should be higher and positive, as profits is in numerator. But if it is in negative then its better to keep it lower.

(c) Asset turnover ratio = Net Sales / Total Assets

It should be also higher, as sales is in numerator. This ratio indicates that how frequently assets are used to convert/generate the sales in accounting period.

(d) Financial leverage ratio = % change in EPS / % change in EBIT = EBIT/EPS

Financial leverage is possible only if business have interest bearing debt funds and/or Stock with preferred dividends.

It is better to be higher if operating profit before interest margin (i.e. EBIT/Sales) is higher than interest on debt funds. Because if Interest is more than EBIT margin then it would lead to reduction in Net profit margin or EPS for stockholders.

2) If Profit margin is positive, for Asset turnover is better to be higher, as higher it is higher will be sales and profit on it. For Financial Leverage it is better to be higher only if ROE is higher than profit margin, otherwise it should be lower.

If Profit margin is negative, for Asset turnover is better to be lower, as lower it is lower will be sales and loss on it. For Financial Leverage it is better to be lower as it would then result in reduction in loss attributable for stockholders.