This is something that has confused me for a while, so i thought i’d put up some heads up
Ratios can be confusing when you have questions asking what happens when a component of numerator increases or denominator decreases or both increases by a certain amount.
Situation 1
Both Numerator and Denominator increases by the same amount
if the Numerator is bigger than Denominator, the overall ratio will decrease.
E.g) if Asset/Equity = 3/2 …if both of Asset and Equity increase by 1, then you now have Asset/Equity = 4/3
A decrease in overall ratio has occured.
If Numerator is smaller than denominator, the overall ratio will increase
E.g) if Net Income/Equity = 2/3,if both of Net Income and Equity increase by 1, then you now have
Net Income/Equity = 3/4
An increase in overall ratio has occured.
Situation 2
Both Numerator and Denominator decrease by the same amount
if the Numerator is bigger than Denominator, the overall ratio will decrease.
E.g) if Asset/Equity = 4/3 …if both of Asset and Equity decrease by 1, then you now have Asset/Equity = 3/2
An increase in overall ratio has occured.
If Numerator is smaller than denominator, the overall ratio will increase
E.g) if Net Income/Equity = 3/4 …if both of Net Income and Equity decrease by 1, then you now have Net Inc/Equity = 2/3
A decrease in overall ratio has occured.
I used both Net Income/Equity and Asset/Equity as examples because they both relate to Return on Equity.
For the components of ROE
Net Profit Margin: Net Income / Revenue : Net Income is the lower number, Revenue is the higher number.
Equity Turnover: Revenue/Equity : Revenue is the smaller number, Equity is the bigger number.
Asset Turnover: Revenue/Assets: Revenue is the smaller number, Assets is the bigger number
Tax Burden: Net Income/EBT: Net Income is the smaller number, EBT is the bigger number
Interest Burden: EBT/EBIT: EBT is the smaller number, EBIT is the bigger number
EBIT Margin: EBIT/Revenue: EBIT is the smaller number, Revenue is the bigger number
Financial Leverage: Assets/Equity: Assets is the bigger number, Equity is the smaller number.
So in this example, if Assets and Equity increase by the same amount, ROE will actually decrease.
Obviously, this is something more of a checklist than something to be memorized.