Question

6. A firm’s return on assets (ROA) decreased during a year in which its net profit margin and its return on equity (ROE) increased. Explain what must have happened to the firm’s asset turnover and equity multiplier.

Answer 1

The firms asset turnover will decrease if the net profit margin has increased and ROA has decreased.

Reason: The assumption here is that the increase in net profit is due increase in sales or decrease in expenses primarily since ROE has increased. Assuming that the sales has decreased ,will also decrease the asset turnover ratio with the given facts.

Illustrated as below:

	Existing	Assumption 1
Sales	1000	1000
Assets	1000	1500
Net margin	500	600
ROA	0.5	0.4
Asset turnover	1	0.666666667

	Existing	Assumption 2
Sales	1000	1200
Assets	1000	1500
Net margin	500	600
ROA	0.5	0.4
Asset turnover	1	0.8

	Existing	Assumption 3
Sales	1000	800
Assets	1000	1500
Net margin	500	600
ROA	0.5	0.4
Asset turnover	1	0.533333333

Case 2: Where net margin has increased and ROE can increase only if the equity has decreased.

In this case the equity multiplier will increase.

Illustrated as below:

	Existing	Assumption 1
Equity	1000	1000
Assets	1000	1500
Net margin	500	600
ROE	0.5	0.6
Equity multiplier	1	1.5

	Existing	Assumption 3
Equity	1000	800
Assets	1000	1500
Net margin	500	600
ROE	0.5	0.75
Equity multiplier	1	1.875