Victor Marcos Hyslop Assignment #4 4/20/2020

The return on equity is a widely used financial measure of profitability for a company.
Equity refers to the total resources available to the company for it to use in order to generate
revenue. Equity is more commonly referred to as stockholder’s equity or owners’ equity. It can
be found on the company’s balance sheet in the last section of it, being the first two sections:
Assets and Liabilities. The formula used to calculate the total value for equity is to take total
assets, and subtract the total liabilities amount to it. The formula is derived from the original
“Assets= Liabilities + Stockholders Equity. The return on equity on its simplest form is expressed
as Net Income / Total Equity. The Net income can be easily found on the last line of the income
statement and/or the first line of the statement of cash flows. A very important term that I will
touch on later in this essay is the use of financial leverage. Financial leverage refers to the use
of debt financing to buy assets. The financial leverage functions as an equity multiplier (it is also
referred to that way) as it magnifies both profits and losses. As a magnifier, the use of leverage
is risky and not necessarily good or bad as it depends on the level of risk aversion that the
company has.
Net Income is a measure of profitability from operations and it is generally calculated on
a yearly basis. The net income value is achieved after subtracting all the expenses from the total
revenue amount. The return on equity formula can be expressed as widely as desired using the
Dupont formula which stands for Net Profit Margin X Asset Turnover X Equity Multiplier. The
extended version of the Dupont formula is written as follows: Tax Burden Ratio X Interest
Burden Ratio X Operating Profit Margin X Asset Turnover Ratio X Financial Leverage Ratio. All
return on equity formulas, including the Dupont, the extended Dupont and the basic Net
Income / Total Equity achieve the exact same value. The main purpose of extending the return
on equity formula to its maximum expression is to visualize the main drivers of its value
changes. After analyzing its drivers, the management team can take decisions that improve the
profitability of the company by managing the drivers. The value for return on equity does not
generally have a benchmark as it widely differs depending on the company’s business. For
example, a railroad company will have a much lower return on equity value than a marketing
company because of the differences in capital expenditures requirements by company. But in
order to provide the general public with a benchmark, there is a general consensus of that a
15% to 20% return on equity value is “good”.
Using a very simple formula for the return on equity which is return on assets times
financial leverage equals return on equity, a test on the way that managing each component of
the formula drives the value for return on equity is performed. The formula that it is used is the
basic Dupont and is expressed as: (Net Income/Revenue) * (Sales/Avg.T.Sales) *
(Avg.T.Sales/Avg.Shareholders’ Equity). In order to have a clear standpoint of the base position
from where the variables will be manipulated in order to assess their relevance on the return
on equity formula, please refer to the appendix at the end of the document to see the table
with the starting values for every input of the formula. The return of assets its purely the
division between Net Income and Total Assets. It is a measure of operational efficiency as it
measures “how well are the assets being used to generate income”. As with the return on
Victor Marcos Hyslop Assignment #4 4/20/2020

equity, the benchmark that makes a return on assets value “good” depends on each company’s
specifics but a 5% return on assets value is generally accepted as a “good” number.
Getting into the testing, I start by incrementing the Net Sales value by 10% and analyzing
its effect on the return on equity value. If the Net Sales value increases by 10% and achieves a
value of $125,386,031, the Return on Equity increases from 1.76% to an outstanding 23.40%.
This effect is predictable but what makes it special is the financial leverage which is initially at a
2.21 level. The financial leverage as expressed at the last sentence of the first paragraph, is a
multiplier for everything that happens within the company’s financials. If after increasing the
value for Net Sales, the value for the cost of goods sold (COGS) is also increased but for 65%,
the results are outstanding. If the COGS are increased times 65%, the ROE turns into a negative
-67.21%. This result happens because of that with the increase in COGS, the gross margin
diminishes into 4mil when before the movement in COGS it was 52mil.
If after the previously done financial movements of increasing revenues and the cost for
good sold the amount of SG&A expenses (Selling, General and Administrative) is increased
times 24%, the return on equity floods deeper into the negative side. From being at an almost
27mil in the beginning, the new value for SG&A expenses is now 33.3mil. Even though the 5mil
difference does not seem like a material number when comparing the value with the other lines
of the model, it accounts for a decrease of 12.27 percentage points on the return on equity
calculation. The ending value for return on equity is of a negative -79.48% percent. The
materiality of such a “little” number relies on that is not little at all when compared against the
newest value for the gross margin which is of 4.2mil. Actually, the increase in SG&A causes the
company to incur in a net loss, making the company totally unprofitable.
In order to maintain a return of equity on a benchmark of around the in-between of 8%
and 10%, there are multiple moves that the company could take. In fact, both the return on
assets and the return on equity could be increased with the same financial decisions as they are
both correlated. First of all, the analyst has to be clear on that incurring in debt if done properly
can serve as a maximizer of profit and both the return on equity and the return on assets
measure. Besides increasing the company’s net sales and net income, and decreasing every
possible cost, there are more complex measures that can be taken. One of those measure is to
maximize the asset turnover measure which stands for times that inventory is bought and sold
over the year-period. And most importantly, the goal has to be to up to the necessities, to
invest in assets as little as possible. This way, the company will increase its profitability
measures.
The outcome that the analyst (I) takes from this assignment is that every financial movement
even if it looks immaterial at first sight, has to be analyzed in depth as it could result being material.
Also, another takeaway is that financials of a company are much more complex than what one could
thing. A clear example is the way that absolutely everything engages with the return on equity formula
directly or indirectly. Every financial decision has to be completely tested on models such as this in order
to assess its efficiency.
Victor Marcos Hyslop Assignment #4 4/20/2020

APPENDIX:

1 Net Sales $ 113,987,301

2 COGS or Variable Costs $ 73,433,392
3 Selling & General & Admin. Expenses $ 26,920,892
4 Other Expenses $ 1,082,000
5 Interest $ 5,000,000
6 Depreciation and/or Variable Expenses$ 8,513,000
7 Cash $ 5,950,000
8 Inventory $ 10,461,000
9 Accounts Receivables $ 9,369,000
10 Total Current Assets $ 25,781,000
11 Total Fixed Assets $ 90,667,000
12 Taxes $ (1,889,000)
13 Accounts Payables $ 4,609,000
14 Current Debt $ 2,000,000
15 Long Term Debt $ 40,000,000
16 Net Worth $ 38,504,000

Return on Equity 1.76%

Return on Assets 0.83%
Financial Leverage 2.21