orders@superbacademics.com
+1 914 979 2828
+1 914 979 2828

Analyzing Financial Statements

1.  Analyze ROA and ROE and how each one fits into Profitability Ratios.

2. What is financial leverage? What are the benefits and risks associated with financial leverage?

Sample Solution

  1. Analyze ROA and ROE and how each one fits into Profitability Ratios.

 

Profitability ratios are financial ratios that expose the ability of a firm to satisfactory return on investment (ROI) and profit. Lesakova (2007) defines the ratios the that show the firm’s ability to generation profit from its sales.  Two of these ratios are ROA and ROE. ROA (return on Assets) measures return that a firm gets from all its assets and is the ration net income to total assets (Kabajeh, Al Nu’aimat & Dahmash, 2012). It is used the show the level of efficiency of the management in generating income using the available resources.

Return on Assets (ROA)= 

 

 

 

The other ratio, ROE (Return on Common Equity) measures the amount of return that a firm earns on its stockholders’ investment and is usually the ratio of net income after tax to equity. It measures the efficiency and effectiveness with which a firm utilizes its investors’ capital (Kabajeh, Al Nu’aimat & Dahmash, 2012). It is the percentage return to owners on their capital invested within the firm.

Return on Equity (ROE)= 

 

Since profitability ratios show a firm’s ability to generate profit and earn a return on the investments on the firm both to ratios fit perfectly in the definition of a profitability ratio. ROA shows the ability to generate profits from the assets owned by the firm while ROE shows the return that can be gained from investing stockholders’ capital.

 

  1. What is financial leverage? What are the benefits and risks associated with financial leverage?

 

Financial leverage entails the employment of borrowed money (debt) in the purchase of additional assets. It is usually used to improve return of equity (ROE) According to Hoang and Phung (2019), however, an excessively high financial leverage escalates the failure risk since debt repayment becomes difficult. Financial leverage favors firms when the return that is raised from the assets bought by debt are greater than the associated debt interest expenses. There are two main benefits of tax leverage namely enhanced earnings and favorable tax treatment. Enhanced earning result from an increase in the earning from assets that do not directly generate dividends for the stockholders. The favorable tax treatment results from the fact that in many countries, interest expenses are tax deductible thus limiting costs for the firm.

The greatest risk that financial leverage presents is the risk of disproportionate losses if the purchased assets cannot generate enough returns to offset the interest expenses. In industries where the barriers to entry are low and thus income generated from the bought items are prone to fluctuations, the firm may suffer an increased risk to bankruptcy (Aharon & Yagil, 2019). Additionally, financial leverage may also result increased risk of stock volatility resulting from the huge swings in a firm’s profits resulting from the high leverage offered by the debt (Aharon & Yagil, 2019).

 

References

Aharon, D. Y., & Yagil, Y. (2019). The impact of financial leverage on the variance of stock returns. International Journal of Financial Studies7(1), 14.

Hoang, K. M. T., & Phung, T. A. (2019). The effect of financial leverage on real and accrual-based earnings management in Vietnamese firms. Economics & Sociology12(4), 299-333.

Kabajeh, M. A. M., Al Nu’aimat, S. M. A., & Dahmash, F. N. (2012). The relationship between the ROA, ROE and ROI ratios with Jordanian insurance public companies market share prices. International Journal of Humanities and Social Science2(11), 115-120.

Lesakova, L. (2007, June). Uses and limitations of profitability ratio analysis in managerial practice. In International Conference on Management, Enterprise and Benchmarking (pp. 1-2).