Question

Assume a from has positive Net Income and the firm has some long-term debt. You would expect the firm's Return on Equity (ROE)_________ to be than the firm's Return on Assets (ROA), and the Internal Growth Rate (IGR) to be ___________ than the Sustainable Growth Rate (SGR).

Answer 1

Assume a from has positive Net Income and the firm has some long-term debt. You would expect the firm's Return on Equity (ROE) to be _higher_ than the firm's Return on Assets (ROA), and the Internal Growth Rate (IGR) to be __lower_ than the Sustainable Growth Rate (SGR).

(1) ROE = Net Income / Average Equity

ROA = Net Income / Total Assets.

So if there is no Debt in the firm, ROA would be equal to ROE. Thus, Equity = Assets

But when the company borrows and incurs a debt, the Equation becomes Equity +Debt = Assets

Therefore the Assets increase and equity becomes less in proportion to the assets. Since the denominator in ROA is more, ROA will be lesser and ROE will be higher.

(2) Both IGR and SGR are derived from ROA and ROE respectively.

  IGR = ROA * Retention Ratio

SGR = ROE * Retention Ratio

When there is debt in the firm, ROE is higher and so SGR is higher than IGR