The three levers of ROE are net margin, asset turnover and financial leverage.
The third lever of ROE, financial leverage, is a measure of how much debt the company carries.
The way in which raising financial leverage increases ROE is a little less intuitive.
If a company adds debt, its assets increase (because of the cash inflows from the debt issuance) and so does its total debt.
Equity = Assets - Total Liabilities
Assets = Equity + Total Liabilities
Since equity is equal to assets minus total debt, a company can decrease its equity as a percentage of its assets by increasing its debt.
ROE
= Net Profit/Revenue x Revenue/ Asset x Asset/Equity
= ROA x Asset/Equity
In other words, assets - the numerator of the financial leverage figure - increases, so the overall financial leverage number rises, boosting ROE.
The third lever of ROE, financial leverage, is a measure of how much debt the company carries.
The way in which raising financial leverage increases ROE is a little less intuitive.
If a company adds debt, its assets increase (because of the cash inflows from the debt issuance) and so does its total debt.
Equity = Assets - Total Liabilities
Assets = Equity + Total Liabilities
Since equity is equal to assets minus total debt, a company can decrease its equity as a percentage of its assets by increasing its debt.
ROE
= Net Profit/Revenue x Revenue/ Asset x Asset/Equity
= ROA x Asset/Equity
In other words, assets - the numerator of the financial leverage figure - increases, so the overall financial leverage number rises, boosting ROE.
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