Hi all,
A company has a net profit marging of 4%, asset turnover 2 and debt-to-assets ratio of 60%. What is ROE?
ROE: net profit margin X asset turnover X leverage ratio
Answer: debt to assets 60%, which means equity to assets 40%, WHY? and leverage ratio 1 /0,4 WHY?
Could someone explain this ?
Thanks
If A=1 and D/A=0.6 this mean D=0.6. E = A-L or 1-0.6=0.4
E/A = 0.4/1 = 0.4
Just some basic algebra. Do it a couple of times and it will stick!
Assuming that debt = liabilities (not true in general, but commonly used to simplify thinking in Corporate Finance and Equity), then:
D/A + E/A = (D + E) / A = A / A = 1
E/A = 1 − D/A
As Pokhim wrote: simple algebra.
To further illustrate what was mentioned above:
You started by Debt to Assets 60%. get used to reason simply like that: for every 1$ of assets you have 0.6$ of debt (hence the 60% ratio). so Equity is 0.4$, because as you know debt + equity = assets.
You now have everything you need for any ratio: Debt = 0.6$ Equity = 0.4$ and Assets = 1$
So Equity/ Assets = 0.4/1=40%
Debt to Equity = 0.6/0.4=1.5
Leverage, which is Assets/Equity (know this) = 1/0.4 = 2.5
Practice again: Lets say Debt/Equity = 1.25
It means for every 1$ in equity you have 1.25$ of debt. So Assets = 2.25$ (debt + equity)
Now you can derive anythnig you want. Debt/assets = 1.25/2.25 = 0.55 or 55%
Assets/Equity = 2.25/1=2.25
with a bit of practice you will see how easy this is.
hope that helped.
cheers