Components of Return on Equity
Return on Equity has three ratio components. The three ratios
that make up Return on Equity are:
1. Profit Margin = Net Income / Sales
2. Asset Turnover = Sales / Assets
3. Financial Leverage = Assets / Equity
Profit Margin measures the percent of profits you generate
for each dollar of sales. Profit Margin reflects your ability to control costs
and make a return on your sales. Profit Margin is calculated by dividing Net
Income by Sales. Management is interested in having high profit margins.
Example - Net Income for the year was $ 60,000 and Sales were
$ 480,000. Profit Margin is $ 60,000 / $ 480,000 or 12.5%. For each dollar of
sales, we generated $ .125 of profits.
Asset Turnover measures the percent of sales you are able to
generate from your assets. Asset Turnover reflects the level of capital we have
tied-up in assets and how much sales we can squeeze out of our assets. Asset
Turnover is calculated by dividing Sales by Average Assets. A high asset
turnover rate implies that we can generate strong sales from a relatively low
level of capital. Low turnover would imply a very capital-intensive
organization.
Example - Sales for the year were $ 480,000, beginning total
assets was $ 505,000 and year-end total assets are $ 495,000. The Asset Turnover
Rate is $ 480,000 / $ 500,000 (average total assets which is $ 505,000 + $
495,000 / 2) or .96. For every $ 1.00 of assets, we were able to generate $ .96
of sales.
Financial Leverage is the third and final component of Return
on Equity. Financial Leverage is a measure of how much we use equity and debt to
finance our assets. As debt increases, we financial leverage increases.
Generally, management tends to prefer equity financing over debt since it
carries less risk. The Financial Leverage Ratio is calculated by dividing Assets
by Shareholder Equity.
Example - Average assets are $ 500,000 and average
shareholder equity is $ 320,000. Financial Leverage Ratio is $ 500,000 / $
320,000 or 1.56. For each $ 1.56 in assets, we are using $ 1.00 in equity
financing.
Now let us compare our Return on Equity to a combination of
the three component ratios:
From our Example, Return on Equity = $ 60,000 / $ 320,000 or
18.75% or we can combine the three components of Return on Equity from our Examples:
Profit Margin x Asset Turnover x Financial Leverage = Return
on Equity or .125 x .96 x 1.56 = 18.75%.
