Question

This year Andrews achieved an ROE of 36.1%. Suppose management takes measures that decrease Asset turnover (Sales/Total Assets) next year. Assuming Sales, Profits, and financial leverage remain the same, what effect would you expect this action to have on Andrews's ROE

Answer 1

Answer:

This action is expected to reduce Andrews's ROE.

Explanation:

The effect of this action can be explained by analyzing the following 3 ratios and the accounting equation.

ROE = Profits / Shareholder’s equity

Asset turnover = Sales / Total Assets

Financial leverage = Total debt / Shareholder’s equity

Total assets = Liabilities + Shareholder’s equity

Since Sales is said to be constant, Asset turnover can only increase by increasing the Total Assets.

Since total assets is equal to addition of liabilities and Shareholder’s equity, an increase in in the total assets implies that either liabilities or Shareholder’s equity or both have increased.

Since the financial leverage remain the same, this implies that both total debt and Shareholder’s equity have increased by the same amount.

Since profits remain the same while the Shareholder’s equity increases, this action is therefore expected to reduce Andrews's ROE.