Financial Return (ROE) Components and Improvement

Understanding Financial Return (ROE)

Financial Return, often measured by Return on Equity (ROE), represents the relationship between a company's net income (after interest and taxes) and its equity (shareholder capital and reserves). It is also known as Return on Capital, as it shows the profit generated by the company relative to the capital contributed by shareholders.

Components of Financial Return

Financial Return (ROE) can be broken down into three key components, often associated with the DuPont analysis:

Sales Margin

This is the first component, representing the company's profitability on sales. It is typically calculated as Net Income divided by Sales. This margin indicates how much profit is generated for every dollar of sales.

Asset Turnover

The second component is Asset Turnover, which measures how efficiently a company uses its assets to generate sales. It is calculated as Sales divided by Total Assets. A higher asset turnover suggests better utilization of assets.

Financial Leverage (Equity Multiplier)

The third component is Financial Leverage, specifically the Equity Multiplier, defined as the ratio between total assets and equity. This ratio indicates the extent to which a company uses debt to finance its assets. A higher ratio means greater reliance on debt.

Improving Financial Return

This breakdown helps determine how to improve financial profitability by acting on these three components. Increasing any of these components, individually or together, generally leads to a more favorable financial return. The possibilities include:

• Increasing the Sales Margin: This can be achieved by raising selling prices and/or reducing costs.
• Increasing Asset Turnover: This involves reducing the level of assets required to support sales and/or increasing sales volume with existing assets.
• Increasing Financial Leverage: Increasing the ratio between assets and equity implies increasing the company's indebtedness. This increase in external resources can have a positive effect on financial profitability in certain situations.

Any combination of these possibilities that results in at least one improvement (while others remain unchanged or also improve) will enhance financial profitability. Therefore, improving financial profitability often requires a coordinated approach, considering how actions affecting one component might influence the others.

The Impact of Financial Leverage

Financial leverage can have a positive multiplier effect on the financial profitability of the company. Numerically, ROE often increases with higher debt levels. While it may seem counterintuitive that increasing external resources (debt) can boost financial profitability, this positive effect only occurs when the return generated by the borrowed funds (investment performance) exceeds the cost of borrowing (interest rate). Financial leverage is a powerful tool that significantly impacts a company's profitability.