Question

You have evaluated the ROA for a company, and the ROE. The ROA is 6%, and the ROE is 15%. The industry average for the debt ratio is .5. How does the Company’s use of debt compare to the industry average?

Answer 1

ROA= net income / total assets = 6%

ROE = net income / shareholders' equity = 15%

Equity to asset ratio = ROA/ ROE = shareholders equity/ total assets

= 6%/15%

= 0.4

Equity to asset ratio determines that what part of the total assets is held by the shareholders or the investors.

If this ratio is 0.4. it means that rest of the part of total assets is owned by the debtholders.

Hence debt ratio for the company = 1-0.4 = 0.6

This means that 60% of the company's assets are in the control of debt holders.

While the industry average is 50%.

This means that the company is using more debt to finance its assets than the industry average and is on the riskier side beacuse of debt and interest obligations. The company has to reduce its debt commitments as it would increase the risk for the investors and shareholders..