Question

Discuss the analysis of the profitability as a breakdown of the return of common equity into its drivers. In your discussion explain why borrowing might lever up the return on common equity.

Answer 1

The return on common equity ratio  is a profitability ratio that measures the ability of a firm to generate profits from its shareholders investments in the company. In other words, the return on common equity ratio shows how much profit each dollar of common stockholders' equity generates.

The drivers of the return of common equity ratio is breakdown into three parts.

1.Profit margin - It is a measure of profitability. It is an indicator of a company’s pricing strategies and how well the company controls costs. Profit margin is calculated by finding the net profit as a percentage of the total revenue. As one feature of the DuPont equation, if the profit margin of a company increases, every sale will bring more money to a company’s bottom line, resulting in a higher overall return on equity.

2.Asset turnover - It is a financial ratio that measures how efficiently a company uses its assets to generate sales revenue or sales income for the company. Companies with low profit margins tend to have high asset turnover, while those with high profit margins tend to have low asset turnover. Similar to profit margin, if asset turnover increases, a company will generate more sales per asset owned, once again resulting in a higher overall return on equity.

3.Financial Leverage - It refers to the amount of debt that a company utilizes to finance its operations, as compared with the amount of equity that the company utilizes. As was the case with asset turnover and profit margin, Increased financial leverage will also lead to an increase in return on equity. This is because the increased use of debt as financing will cause a company to have higher interest payments, which are tax deductible. Because dividend payments are not tax deductible, maintaining a high proportion of debt in a company’s capital structure leads to a higher return on equity