Question

sing the data below, what is the manager most likely to conclude about the change in the company's performance from 2015 to 2016?

2016 2015

ROE = 28.3% 25.7%

EBIT margin 20.3% 22.6%

Interest burden 85.9% 87.0%

Tax burden 61.2% 61.0%

Total asset turnover 0.94 0.88

Financial leverage 2.83    2.45

Answer 1

ROE can be found by Dupont five factor model

ROE=EBIT margin*Interest burden*tax burden*asset turnover ratio*financial leverage

ROE= (EBIT/Sales)*(Pretax Income/ EBIT)*(Net Income/ Pretax Income) * (Sales/Total Assets) * (Total
Assets/Total Equity)

2016 ROE increased mainly driven by financial leverage followed by asset turnover ratio despite of fall in other ratios like EBIT margin and interest burden.

One scenario is company build up the assets (increased capacities) majorly by debt funding lead to increase in the financial leverage and consequent increase in the sales. Because of high asset build-up, during initial years the depreciation would be high resulting a fall in EBIT margin. Furthermore, due to new debt, interest expenses would have gone up led to fall in the interest burden ratio. However, overall ROE improved due to increase in financial leverage and asset turnover ratio.