In my earlier article on the DuPont System,I put forth what the DuPont System is and attempted to elaborate on its three (3) components. There should not have been any problems in understanding Return on Assets (ROA) since ROA essentially consists of profitability coupled with the efficiency of using the company’s assets to generate the desired level of ROA %.
But,what about this so-called Financial Leverage Multiplier (FLM),which is defined as the ratio of Total Assets to Shareholders’ Equity –namely the degree of reliance on financing from borrowing and bonds?
Let’s us go back to basics. A higher Total Assets to Shareholders’ Equity means a higher level of leverage as the denominator,the shareholders have less stake in the total assets. For example,total assets is $1million and shareholders’ funds might be a $500,000 which is 2x compared to say a shareholder fund of $1,000 which is 100x which will then lead the company to extremely high gearing exposure. During a recession,when returns from business dip,it will definitely not able to service its interest from these high borrowings.
However,if we were able to MANAGE the efficiency of leverage or the level of financial efficiency we can definitely see a rise in Return on Equity,which all shareholders love to have (on the proviso that ROA % is also on a rising trend)
Illustration:
| Yr | (a) Assets Turnovers Sales/Avg Assets | x | (b) Return on Sales Net Income/Sales | = | © ROA Net Income/Avg Assets | x | (d) Financial Leverage Avg Assets/Avg Equity | = | (e) ROE Net Income/Avg Equity |
| 1 | 1.5 | x | 4.1% | = | 6.2% | 2.5 | = | 15.5% | |
| 2 | 1.8 | x | 5.2% | = | 9.4% | 3.0 | = | 28.2% | |
| 3 | 2.3 | x | 7.1% | = | 16.3% | 3.1 | = | 50.5% |
If you were to look at the above illustration,if you are able to manage a higher efficient use of your company’s assets and its profitability level,and simultaneously able to efficiently use the Financial Leverage to your advantage,you can definitely see the ROE % increases many fold.
However,what if we have another case where there is no improvement at all for ROA %,BUT the FLM has increased dramatically and hence ROE% increases many folds? This I believe is a blatant case of using “others people’s money to roll”. This will happen when a high rise politician/powerful businessman can borrow as much as he wants.
Incidentally,this use of infinite leverage fueled the Leveraged Buyout (LBO) era of the 1980s in the US. So long as the acquired company’s Return on Assets % exceeded the cost of funds,the entrepreneur will make money. This is normally done by disposing off the acquired company’s assets so as to increase it ROA %. However,most LBO’s failed either because the businesses could not earn enough on its Return on Assets % to service their costs of funds and other cash outflows or because the assets managed could not be reduced as planned.
Nowadays,bankers are more cautious by stipulating certain covenants like higher levels of shareholder funds to total capital in their lending agreements.
- DuPont System:Overview &ROA &ROE
- Articles Written On DuPont Model
- Financial Ratios on Assessing The LEVERAGE or GEARING Of A Company
- Glossary Of Accounting &Finance Terms-Alphabet T
- Financial Ratios On The Assessing Of The Profitability Of A Company
- Balanced Scorecard:Examples of Financial Perspective,KPI
- Financial Ratio on Assessing The ACTIVITY Of Assets Utilised
FCCA,CA(MIA)with more than 26 years of post-qualifying working experiences. Previous working stints with one of the big accounting four,Regional GFC & Group Treasurer in a group of Malaysian and Group CFO in Singapore public listed concern.Also author to another very popular free educational accounting cum finance blog:http://basiccollegeaccounting.com under the branding of College Accounting Coach.
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