Question

A firm with a low net margin and low total asset turnover could still provide investors with a high return on equity. true or false?

Answer 1

Answer: True, a firm with a low net margin and low total asset turnover could still provide investors with a high return on equity (ROE) by increasing the Financial Leverage.

Reason:

As, Return on equity (ROE) can be broken down into net profit margin (how much profit the company gets out of its revenues), asset turnover (how effectively the company makes use of its assets) and Leverage (a measure of how much the company is leveraged).

Formula:

The above chart shows Dupont analysis which depicts that ROE is composed of these three ratios.

So, if the company increases it leverage by taking on more debt it could still provide high return on equity regardless of low net margin and low total asset turnover. Although increasing ROE by increasing only leverage is a bad sign for shareholder and therfore Dupont analysis is to done to find out the real reason of increasing ROE.

Note: Financial leverage is the amount of debt that an entity uses to buy more assets. Leverage is employed to avoid using too much equity to fund operations. An excessive amount of financial leverage increases the risk of failure, since it becomes more difficult to repay debt.