Which of the following is the correct formula for the breakdown of ROE?
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A. B. C. D.B
By definition: ROE = Profit Margin x Total Asset Turnover x Financial Leverage
The correct formula for the breakdown of Return on Equity (ROE) is:
B. Profit Margin x Total Asset Turnover x Financial Leverage.
Return on Equity (ROE) is a financial ratio that measures the profitability and efficiency with which a company generates returns for its shareholders' investments. It indicates how effectively a company utilizes its shareholders' equity to generate profits.
Let's break down the formula and explain each component:
Profit Margin: Profit Margin is a measure of how efficiently a company generates profits from its sales. It is calculated by dividing the Net Income by the Revenue. Profit Margin represents the portion of each dollar of revenue that is turned into profit. It indicates the company's ability to control costs and manage pricing. A higher profit margin implies a more efficient and profitable operation.
Total Asset Turnover: Total Asset Turnover is a measure of how efficiently a company utilizes its assets to generate sales. It is calculated by dividing the Revenue by the Average Total Assets. This ratio indicates how effectively a company utilizes its assets to generate revenue. A higher total asset turnover indicates better asset utilization and efficiency.
Financial Leverage: Financial Leverage refers to the use of debt financing to finance a company's assets. It amplifies the return on equity by allowing a company to generate higher profits with a smaller equity base. Financial Leverage is calculated by dividing Average Total Assets by Average Shareholders' Equity. A higher financial leverage ratio indicates a higher level of debt and potential risk.
By multiplying these three components together, we obtain the breakdown of ROE. The Profit Margin measures the company's ability to generate profit from each dollar of revenue. The Total Asset Turnover measures the efficiency of asset utilization. Finally, the Financial Leverage amplifies the return on equity by employing debt financing.
Therefore, the correct formula for the breakdown of ROE is Profit Margin x Total Asset Turnover x Financial Leverage (Option B).