Question

In 2017, Benvolio Enterprises had a return on assets of 12% and a return of equity of 16%; in 2018 those ratios were 13% and 21% respectively, Given this, a reasonable assumption would be that Benvolio: A. decreased profitabilty. B. decreased leverage. C. increased leverage

Answer 1

Option (C) is correct

Return on assets is given by:

Return on assets = Net income / Average assets

While, Return on equity is given by:

Return on equity = Net income / Average equity

In 2017, return on assets was 12% and return on equity was 16%

In 2018, return on assets was 13% and return on equity was 21%

Return on assets and return on equity, both increased in 2018, indicating that there was increase in net income in 2018. So, profitability is increased in 2018.

Assets = Liabilities + Equity

Return on assets increased by just 1% while return on equity increased by 5%. It shows that at a given level of assets, the equity, in denominator in the above formula, would have decreased as well. It further means that there is an increase in liabilities or leverage in 2018 that resulted in decrease in equity to maintain the same amount of assets.