what does ROE and ROTC spread mean?

CFA Level I FRA
#1

An analyst is examining the operating performance ratios for a company. A summary of the company’s data for the three most recent fiscal years along with the industry averages are shown below:

Return on total capital(ROTC):

Industry:24%

20x5:26.6%

20x4:27.3%

20x3:28.4%

Return on common equity:

Industry:10%

20x5:12.6%

20x4:15.5%

20x3:20.2%

Return on equity(ROE):

Industry:8%

20x5:12.1%

20x4:14.7%

20x3:18.9%

Based on the above data, the analyst’s most appropriate conclusion is that the trend in ROE:

A. relative to return on common equity implies declining leverage and financial risk

B. relative to industry average reflects underperformance due to weak management.

C. relative to ROTC implies increasing leverage and financial risk.

the answer is C

Here is the description of the answer:

Return on equity (net income / average total equity) includes both common equity and preferred equity in the denominator, but not debt.

Return on total capital(EBIT / average total debt + average total equity) includes both equity and debt.An increasing spread between ROE and ROTC implies increasing debt in the capital structure, which reflects increasing leverage and financial risk.

I have read the description several times, but still don’t understand why does ROE and ROTC spread’s increase indicates the financial risk.

Anyone can help?

#2

ROTC includes debt. If the spread is increasing (difference between ROE and ROTC) this means the company is taking on more debt… Increased debt is increased leverage which is increased risk.

#3

In this question:

ROTC = EBIT / (equity +debt)

ROE = NI / equity

In this question, ROTC - ROE:

20x5:14.5%

20x4:12.6%

20x3:9.5%

We can see the spread is increasing, but if the debt is expanding, I think the spread should decrease because it is in the denominator of ROTC formula.

Here my biggest confusion is that how can these two ratios be compared, I think their numerators and denominators are totally different.