Can someone explain the relationship between DFL and ROE?
As far as I understand, DFL increases as usage of debt increases. Using more debt will lead to a higher interest expense therefore Net Income will decrease. A = L + E. Since L increased, E should decrease to maintain the balance.
If Net Income decreased and Equity decreased as well, does the ROE ratio increase or decrease?
I think you confusing scenarios. I see when you say “more leverage” you mean a higher debt but lower equity, which won’t necessarily happen (Do not confuse % with dollar amounts). I mean, when you issue debt, your equity is unchanged, or does it drop? No, right?
Equity level is done (in dollars), is the capital given from the shareholders, and debt is rised to get an optimal capital structure.
So do not move all variables at once, only move the correct variables: debt, interest expense and as a result, net income.
You said more debt rises interest expense and reduces net income, and since Equity is UNCHANGED, the ROE will fall. (ROE = net income / average equity)
I’m aware that debt must enchance ROE, but not from a drop in Equity as you say, it comes from higher sales or income. Why? Remeber A = D + E, equity is given (constant this time), and we rise debt, so total assets (A) will rise. A higher level of assets MUST enhance income, thats why we issue debt in first instance. So income growth in a given rate must rise ROE even if your DFL is higher. But in real life, there is not always success, maybe we issue debt and just expenses rise… we lose.
You cannot rise debt indefinitely, your financing risk is intolerable, so you will need to rise more equity, changing your ROE to a lower level. This forces makes ROE, ROA to change.
This very simple as there is a very straighforward relationship:
As long as the interest rate on the addtional debt is below the ROA (NI/Total Assets) an increase in leverage will always increase ROE (NI/Equity). Once the interest rate on the additional debt becomes greater than the ROA increasing leverage will decrease ROE. This effect is known as the leverage effect.
Just try to make an example with simple numbers so that it becomes clear.