How is return on assets (ROA) calculated and what does it measure?
Return on Assets = Net Income / Average Total Assets
It measures the percentage of return that was provided on the total amount of capital invested in assets.
To analyze the causes of changes in return on assets (ROA), ROA can be disaggregated into what two other ratios?
- Total asset turnover
- Net profit margin percentage
Changes in either one or both of those ratios will affect return on assets
ROA = Total Asset Turnover × Net Profit Margin Percentage
How is the total asset turnover ratio, an element of return on assets according to the DuPont model, calculated and what does it indicate?
Total Asset Turnover = Sales Revenue / Average Total Assets
It indicates the overall efficiency of the company’s use of its investments, that is, the amount of sales revenue the company is getting from the use of its assets.
How is the net profit margin percentage, an element of return on assets according to the DuPont model, calculated and what does it indicate?
Net Profit Margin Percentage = Net Income / Sales Revenue
It indicates the profitability of the sales a company is getting from the use of its assets.
Return on assets (ROA) is a function of the total asset turnover and the net profit margin percentage according to the DuPont model.
Why, mathematically, does the total asset turnover × the net profit margin percentage equal return on assets?
Total Asset Turnover = Sales / Average Total Assets
Net Profit Margin Percentage = Net Income / Sales
When the total asset turnover ratio is multiplied by the net profit margin percentage, “sales” in the numerator of the total asset turnover and in the denominator of the net profit margin percentage cancel each other out. What is left is return on assets: net income divided by average total assets.
Why, from an analysis standpoint, is a company’s return on assets affected by its total asset turnover and net profit margin percentage?
Return on assets is affected by:
- The amount of sales revenue a business is getting from its assets (its total asset turnover)
- The profitability of those sales (its net profit margin percentage)
As either of those two individual ratios improves or gets worse, the company’s return on assets will also improve or get worse.
How is return on equity (ROE) calculated, and what does it measure?
Return on Equity = Net Income / Average Total Equity
It measures the amount of earnings produced by the business on its equity.
To analyze the causes of changes in return on equity (ROE), ROE can be disaggregated into what two other ratios?
- Return on assets
- Financial leverage ratio/equity multiplier
ROE = Return on Assets × Financial Leverage Ratio/Equity Multiplier
How is return on assets, an element of return on equity according to the Extended DuPont model, calculated and what does it indicate?
Return on Assets = Net Income / Average Total Assets
It indicates the percentage of return that was provided on the total amount of capital invested in the company’s assets.
How is the financial leverage ratio/equity multiplier, an element of return on equity according to the Extended DuPont model, calculated and what does it indicate?
Financial Leverage Ratio/Equity Multiplier = Average Total Assets / Average Total Equity
It expresses the company’s amount of financial leverage. It relates total assets to assets financed by shareholders. The larger the equity multiplier is, the smaller is the proportion of assets financed by shareholders, and the greater is the company’s financial leverage.
Return on equity (ROE) is a function of the total return on assets and the equity multiplier according to the Extended DuPont model.
Why, mathematically, does return on assets × the equity multiplier equal return on equity?
Return on Assets = Net Income / Average Total Assets
Financial Leverage Ratio/Equity Multiplier = Average Total Assets / Average Total Equity
When return on assets is multiplied by the financial leverage ratio, “average total assets” in the numerator of the financial leverage ratio and in the denominator of return on assets cancel each other out, leaving net income divided by average total equity, which is return on equity.
Why, from an analysis standpoint, is a company’s return on equity affected by its return on assets and its financial leverage ratio/equity multiplier?
A company’s return on equity is actually affected by three ratios, two of which together equate to return on assets. They are:
- Efficiency of asset usage (measured by the total asset turnover)
- Efficiency of operations (measured by the net profit margin)
- Financial leverage (measured by the equity multiplier)
The total asset turnover multiplied by the net profit margin percentage equals return on assets. Return on assets multiplied by the financial leverage ratio equals return on equity.
If a company can improve any of the three ratios above, its return on equity will improve. Similarly, deterioration in any of these ratios will cause a deterioration of the return on equity.
How does a change in the numerator of ROA affect the ratio?
The numerator of return on assets is net income, and the denominator is average total assets.
An increase in net income increases ROA, while a decrease in net income decreases ROA.
How does a change in the denominator of ROA affect the ratio?
The denominator of return on assets is average total assets, and the numerator is net income.
An increase in average total assets decreases ROA, while a decrease in average total assets increases ROA.
What are the three accounting policies that contribute the most to inconsistencies in ROA and ROE when they vary due to accounting policy choices?
- Inventory cost flow assumption used
- Depreciation method used
- Asset capitalization policy used
How does using the FIFO inventory cost flow assumption affect ROA and ROE in a period of rising prices, compared with using LIFO?
In a period of rising prices, both ending inventory and net income will be higher under FIFO than under LIFO. However, the difference in net income will be proportionately greater than the difference in total assets, so ROA and ROE are usually higher under FIFO than under LIFO.
How do accelerated depreciation methods affect ROA and ROE, compared with straight-line depreciation?
Accelerated depreciation methods cause both net income and total assets to be lower in the early years of fixed assets’ lives in comparison with straight-line depreciation.
The effect will be proportionately greater on net income than on balance sheet items, so ROA and ROE are generally lower in the early years of an asset’s life when compared with straight-line depreciation.
How does asset capitalization policy affect ROA and ROE?
Compared to expensing an asset purchase, capitalizing an asset increases ROA and ROE in the year of purchase but decreases both ratios in subsequent years due to depreciation.
What factors influence net income because they are subject to interpretation, assessment, judgment, and opinion?
- Estimates such as useful life and salvage value of fixed assets, allowance for credit losses, warranty costs, and sales returns
- Accounting methods such as cost flow assumptions for inventory
- Pressure on accountants by financial statement users
- Diversity of needs among financial statement users leads to analysts making adjustments to reported net income for analysis purposes
Income determination requires judgment in making these estimates, making “income” not a precise measurement.
Why might accountants face pressure in financial reporting?
They may be pressured to choose “acceptable” measures instead of “appropriate” measures, especially in “gray areas” of accounting.
Analysts must recognize these pressures when evaluating reported income.
What should an analyst consider when evaluating segment profitability?
Segment information may depend on accounting allocations of revenues, common costs, and joint expenses, making it subject to manipulation by management.
Analysis should focus on trends rather than absolute levels.
Why is revenue from continuing operations important?
Because it is more predictive of future revenue growth than revenue from non-core sources or discontinued operations.
Primary revenues from continuing operations are more likely to continue and grow in the future.
What factors contribute to the stability of revenue?
- A constant source of revenue
- Long-term contracts
- Long-term customer relationships
Stable revenues are more likely when a company does not need to find new sources of revenue every period.
How can customer base concentration affect a company?
Relying on one large customer can be risky if that customer is lost, especially if the reliance is growing.
A concentrated customer base can negatively impact a company if the key customer relationship is disrupted.
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A.1. Comparative Financial Statement Analysis11
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A.2. Financial Ratio Analysis150
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A.3. Profitability Analysis37
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A.4. Advanced Financial Topics60
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B.1. Risk and Return Fundamentals57
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B.2. Long-Term Financial Management124
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B.3. Raising Capital and Financial Markets38
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B.4. Working Capital Management105
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B.5. Corporate Restructuring and Valuation39
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B.6. International Finance68
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C.1. Cost-Volume-Profit (CVP) Analysis52
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C.2. Marginal Analysis and Decision Making57
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C.3. Pricing Decisions86
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D.1. Enterprise Risk Management (ERM)80
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E.1. Capital Investment Analysis and Cash Flows34
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E.2. Capital Investment Methods and Risk97
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F.1. Business Ethics and Fraud30
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F.2. IMA Code of Ethics and Fraud Triangle14
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F.3. Organizational Ethics and Culture64
