Return on Assets (ROA) of Firms A and B
Thus, the ROA of firms A and B is identical. While firm A has higher profit margin, B firm has higher assets turnover. Thus, the earning power is affected by two variables, namely, profit margin and assets turnover. Assets turnover ratio can further be segregated into inventory turnover, debtors turnover and fixed assets turnover ratios. Likewise, profit margin can be decomposed into gross profit, operating profit, profit before taxes and so on.
The usefulness of the integrated analysis in the fact that it presents the overall picture of the performance of a firm as also enables the management to identify the factors which have a bearing on profitability. In Example, if firm B could improve its profit margin even marginally, say, from 1 per cent to 2 per cent, its earning power (ROA) will he doubled, assuming sales are not affected. Similarly, firm A can double its earning power simply by a marginal increase in its investment turnover, as, it indicates that the assets are used more efficiently, that is, more sales per rupee of investments. The two components of this ratio namely, the profit margin and the investment turnover ratio, individually do not give an overall view as the former ignores the profitability of investments, while the latter fails to consider the profitability on sales.
The profitability analysis based on ROA can be extended further for a detailed examination of the return on equity (ROE). It is the most important measure of financial performance from the point of view of equity holders. The ROE can he decomposed into three following principal components:
The three components in the ROE are indicative of net profit margin (profitability), assets turnover (efficiency in operations) and financial leverage (indicating the extent to which assets are financed (owners funds). Thus, the ROE is the product of the following three ratios:
Net profit ratio (x) Assets turnover (x) Financial leverage/Equity multiplier
The equation indicates that the management of the firm has three levers through which it can control ROE: (i) the net profit margin per rupee of sales, (ii) the sales generated per rupee of assets employed and (iii) the amount of equity used to finance the assets. While profit margin Summaries profit performance as reflected in the income statement of a firm, assets turnover and financial leverage measure its performance with respect to assets and liabilities side of its balance sheet respective. Thus, these three levers capture the major elements of financial performance of a firm.
Suppose in Example. Firm A uses equity capital of Rs 2 lac and B of Rs 2.5 lac in financing total assets of Rs 4 lac. The financial leverage of A is 2 (Rs 4 lac assets/Rs 2 lac equity) and of B is 1.6 (Rs 4 lac/Rs 2.5 lac). The ROE for A and B can be computed using Equation 7,65.
Net profit ratio X Assets turnover x Financial leverage
10 % * 1 * 2 = 20% (A) ,
1% * 10 * 1.6 = 16% (B)
Thought the ROA for firms is the: same (10%), A has higher ROE (20%) than B (16%), The higher ROE of A primarily can be attributed to its higher financial leverage. The management of B can explore the possibility of increasing its financial leverage and thereby enhance the ROE of its equity owners. To will profitable for B to employ more debt if the ROA is higher than the cost of debt. The relationship between ROA and ROE may he expressed as per Equation 7,66.
ROE = (ROA – Interest cost + Assets) X Assets + equity
The three-component model of ROE (Equation 7.66) can he broadened further to consider the effect of interest and tax payments. The net profile ratio is to he aggregated in the following three elements (the assets turnover and financial leverage ratios remaining unchanged).
A 5 way break-up of ROE enables the management of or firm to analyse the effect of interest payments and tax payments separately from operating profitability. To illustrate further assume 8 per cent interest rate, 35 per cent tax rate and other operating expense of Rs 3,22,462 (Firm A) and Rs 39,26.462. (Firm B).