ECONOMICS
Return on Equity measures the extent to which a firm is able to manager investors’ funds effectively by indicating whether the value of the company is growing at the accepted rate. Return on assets is ratio that indicates the amount of profit a firm earns for its assets. Such asset includes property, inventory and accounts receivable. This measure is normally a product of management of debt-equity, asset turnover and the operating performance. If a company can acquire debt and use it to get higher return than this cost , the resulting leveraging leads to more revenue for investors in form of increased equity (Boundless, 2016).
The return on assets is connected to both the asset turnover and the profit margin and it indicates the investors and creditors return rates. It also measures how effectively the firm is able to control costs and utilize resources. A firm may have low profit margin yet its return on assets is high since its assets turnover is higher (Jan, 2013).
Financial leverage refers to the extent to which a firm utilizes fixed-income securities like preferred equity and debt. It refers to a firm using debt to obtain more assets. The firm’s financial leverage will increase as its use of debt financing improves. The benefits of financial leverage include the multiplication of the finances that are invested in operations and its usage in buyouts and acquisitions. In a short period when a business has a certain objective for growth, finance leveraging is very beneficial. On the other hand, the higher debt level can put the firm into a higher leverage state which exposes it to more risks. Another risk is the high interest rates required for compensating investors for leveraged loans and bonds (Boundless, 2016).
References
Boundless, (2016). “Benefits and Risks of Operating Leverage.” Boundless Finance Boundless,. Retrieved 14 Feb. 2017 from: https://www.boundless.com/finance/textbooks/boundless-finance-textbook/capital-structure-13/thinking-about-operating-leverage-105/benefits-and-risks-of-operating-leverage-450-3798/
Boundless,(2016). “ROE and Potential Limitations.” Boundless Finance Boundless. Retrieved 14 Feb. 2017 from https://www.boundless.com/finance/textbooks/boundless-finance-textbook/analyzing-financial-statements-3/the-dupont-equation-roe-roa-and-growth-44/roe-and-potential-limitations-221-3897/
Jan, O., (2013).Net Profit Margin. Retrieved from: http://accountingexplained.com/financial/ratios/net-profit-margin
