 Hello and welcome to this session in which we would look at profitability ratios to be more specific in this session I would look at return on assets return on capital return on equity Then I will look at financial leverage as it relates to return on equity because that's an important ratio As always before I start I would like to remind you to connect with me on LinkedIn Subscribe to my YouTube. Please like and share my lectures if they're helping you and on my website farhatlectures.com You will find additional resources whether you are an accounting students And specifically a CPA candidate. Now, I do not have a full CPA review course. I don't replace your Becker, your Roger, your Wiley, your Glyme CPA course. I supplement your CPA course. I help you understand the material better because the CPA prep courses They don't go in depth into the material because that's not what they do. They review the material with you I don't review it. I explain it from scratch as it as this is the first time you are looking at it So I strongly suggest you take a look at my website Let's start by looking at return on asset So I'm going to explain it briefly work an example Then we're going to put all three ratios or or all ratios together as they relate to return on equity in terms of financial leverage Let's start by looking on return on assets. What is return on assets? So I'm going to explain the ratio work a simple example then move on then at the end We'll wrap up the whole picture every time you hear the word return on asset If you are taken a basic income tax a basic financial accounting, it means net income Minus Dividend, okay Now if you are a little bit more sophisticated if you are taken an investment course or an advanced course a return means earnings before Interest and taxes or EBIT. So for our purposes, you have to be careful in your course Whether they are considering return as net income usually they consider it net income minus dividend and basic financial accounting courses and advanced courses They considered return is EBIT. Now. Why do they consider it EBIT and not and not net income? So let me explain this to you. So you'll start to get your head wrapped around this idea Earnings before the interest and taxes. So what we're doing is we are not taking interest and taxes into account now Why why? Because if you are running the company if you are running the company Interest has to do with how you finance the company not how you run your operation. So interest basically is a finance Number so it has nothing to do with your day to day operation Well, some companies they use zero finance. They are sorry. They use zero debt Therefore, they will have no interest and some companies would rely more on that they will have a lot of interest Therefore if you are comparing two companies, don't take interest into account Well, you will take it in another measurement But don't take it into account when you are looking at return on assets. How well they are operating their business in terms of asset utilization because the different companies will be financed differently And this is what I will show you in this recording Taxes guess what taxes has to do with Uncle Sam in the US with the government? So also don't include the taxes because you have no control over taxes if the government raise your taxes Let's assume you operate in state a and another company operate in state B Well, they might have two tax rates It has nothing to do with how you operate the business is how it has to do is where you operate Therefore keep that separately and that's why in advanced courses in the numerator. We use EBIT and not net income because net income has Factors interest and taxes. So that's why we use EBIT for that purpose and total assets. Usually what you do is in the denominator We use usually average asset, which is average assets is the beginning Plus the end of the year asset divided by two or year one Plus year two divided by two, which is year one is the beginning of the year year two is the end of the year So usually you would use the average in the denominator Why do we why do we use the average in the denominator is because earnings earnings? Remember earnings your income is for a period of time Your assets is for a point in time. Remember assets are on the balance sheet. They're only one figure Therefore you cannot take all this performance and compare it to a point in time So what you do is you take your beginning assets Plus your ending asset and you average them in this way you are comparing your earnings to the average asset So that's why we use in the denominator averages So let's work a quick number just to illustrate this concept then we can move on. So let's assume your earnings Before interest and taxes is $40 and you have $400 in total assets an average total asset. What we say is return on asset is 10 percent What does that mean? Let's try to interpret this It means you have $400 of assets and of these $400 you are earning you are generating from them $40 in other words for every dollar an asset you are milking out you are youth. It's basically an asset utilization Ratio you are milking out 40 cent now. Obviously you want this ratio to be higher. How can you make this ratio higher? You have three options you can obviously if you want to keep your assets the same increase your earnings or if you cannot increase your earnings Reduce your assets or a combination of increasing your earnings and reducing your assets and this will increase your return on Assets, let's take a look at another ratio called return on Capital again, I don't have to tell you what return is return is EBIT now. We are taking our EBIT return on on EBIT and divide in it by long-term Capital long-term capital is the money that's invested by the stockholders the people that's going to give you money and The bondholders for long term. So this is basically You're looking at how well you are utilizing the money that's provided by Capital providers stockholders and bondholders in generating more profit So ROI compare EBIT to total asset return on capital express EBIT as a fraction of long-term capital That is stockholders equity plus long-term debt it measures again operating earnings per dollar of long-term capital How well you are you how well you are? Generating money from your capital. Okay. Now. Obviously you want this number as well to be high So if we're talking if you have EBIT of 40 and your long-term capital, let's assume it's 200 What's 40 divided by 200? Well, that's That's around 20 percent. That's around 20 20 percent So in other words in every dollar in every dollar bondholder and stockholder put together But notice this ratio combined the bondholder and the stockholders together You are generating 20 cent now. Obviously, we want to break this down We want to know the how much you are getting on return on equity versus the remaining is return on that and let's talk about Return on equity. Well return on equity here. We are dealing with equity equity focuses on the profitability of Equity investments. How do we compute this? It's equal to net income realized by shareholders That they have invested in the firm now. We are looking at income net income net income as In relationship to the shareholders equity So here we are using net income because what matters the shareholders is what's left over because remember the shareholders They get paid after the bondholders are paid. So you have to pay your interest You have to pay your taxes because well, if you're a if you're a return on equity, you don't care what they did in EBIT As a performance If you're a shareholder, I want to know after you pay the interest after you pay the taxes How much is left for me? Therefore you would look at net income again What you do is in the denominator you will average shareholders equity because shareholders equity is a balance sheet number So simply put just to show you a number because we're gonna dive into this little bit further We're gonna dive a lot into return on equity also in the next session Let's assume that income is again 40 dollars. You have equity of 100 Return on equity is 40 and that's pretty high return on equity Okay, it means when you invest a dollar amount in this In this company You are generating 40. Well, if that's if that's true, you should you you really need to question the company's performance They might be committing some fraud or Because return on equity of 40 percent is pretty high. The reason I said this is just I wanted to make sense to you So return on equity 40 percent is high means in Two and a half years you'll basically double your money in a sense. Okay, it could happen But I will question it So return on equity remember we saw this in prior session is one of the two basic factors in determining growth Rate of earning you remember g we use we use return on equity to compute g So sometime it's reasonable to assume that future roe will approximate the past But high roe does not necessarily imply a firm future roe will be higher Remember accounting figures are always talking about the past. So we have to be very careful We have to be very careful also all the numbers that we look at especially when we talk about net income and ebit Remember those numbers are accounting figures And this is important to always remember. What does that mean? Well, I'm a cpa. I'm an accountant It means you can easily the the company can easily manipulate earnings Using different techniques, which we'll talk about later on at the end of this chapter I will have a list of techniques that the companies might use to select different accounting treatment for different transaction Which in turn would influence your net income and would influence your ebit So always keep in mind those numbers are accounting numbers So it could be dangerous to accept historical value also as indicator of future values You have two problems one they're accounting to you don't know that you don't know the future So data from recent past may provide information regarding future performance But you should always look when you're evaluating a company at future performance not past performance We already know what past performance is. It's in front of us. We're looking at it. That's that's not really as helpful What's helpful is what's going to happen in the future. What's going to happen in the future? It's gonna it's going to depend on your knowledge and in your on your analytical skills and how you read the events Now what we're going to do we're going to look at the financial leverage financial leverage What is leverage leverage is what you when you are using something else to help your lever Well, here we're going to be using financial leverage, which is that how does that effect specifically return on equity So how does that specifically affect return on equity? So to illustrate this concept We're going to be looking at at at two examples One with company would know that and some would that okay So return on equity is affected by the firms that mix That equity mix as well as the interest rate on the debt and we're going to illustrate this through figures So suppose know that a company called know that is all equity Finance and has a total assets of 100 million. So we are dealing with a company with 100 million of assets Incorporate tax rate for simplicity is 20 percent. Let's take a look at this company. So We have three scenarios bad year normal year and good year. Let's start with good year And no, I'm sorry. Let's start with normal year normal year sales is a million Okay, sales is a million EBIT Is 10 million earnings before interest and taxes ROI return on asset. Well, what does that mean? It means we're going to take this 10 divided by this 100 million of assets 10 percent Net profit they made a profit of 8 million Return on equity, which is what it's EBIT EBIT divided by Divide sorry return on equity is net income net income, which is this this number here divided by 100 million Return on equity is 8 percent. That's normal year. Let's look if sales went down by 20 million If sales went down by 20 million EBIT is 5 Earnings before interest notice It's literally cut down by half went from 10 to 5 return on Return on asset is 5 percent against same computation Which is 5 EBIT divided by 100 million return net profit is 4 million And return on equity is 4 percent. So notice what happened Although your your your your sales did not go down and have your profitability Ratios were cut down and half Let's assume in good years in good years. You have 100 a good year is 120 million EBIT is 15 million Return on asset is 15 return on asset is 15 percent Net profit is 12 million return on equity is 12 percent So those are basically durations The first thing you want to see is that the effect when there's a small change it affects the ratios much much more So although this is approximately 20 percent. Well, it's not more more than 20 percent on the way down But let's say around 20 percent your ratios are affected They're doubling they're in other words They're doubling down went from 10 to 5 and 8 to 4. So you have to be aware of the of this Also to compare this let's look at at a company with some debt. It's identical to know that But has financed 40 million of its 100 million in assets So remember this company has 100 million in assets initially we thought it's all equity Now what's going to happen is we're going to say no, it's not all equity Of this 100 million 40 million is that in 60 million equity. So this is the debt now We are introducing the debt remember when you have that you have to pay Interest in other words your profit will be shared with the debt holders Okay, and the interest is 8 and it pays annual interest expense of 3.2 million So they have to make this payment of 3.2 million. Let's take a look what happened to our ratios When we introduce some debt to this return on equity equation. Okay Remember before we start roa roa it doesn't make a difference whether you have that or not because roa is computed Earnings before interest and taxes. So for roa, we're not gonna discuss roa and the reason is because it's the same What's going to be the effect on it's going to be on roa not roa Starting with the normal year Your earnings before interest and taxes is 10 million notice 10 million the same scenario Net profit is under the know that again 8 million is the same your return on equity is 8 So we already looked at know that let's look at some debt for some debt What's going to happen to your net profit your net profit will be lower. Why will yet? Why will why will your net profit be lower? It's because you have to pay interest then deduct your taxes Well, obviously the the interest will help reduce your taxes, but nevertheless notice your profit is lower So from a profit from a profitability perspective your profit is lower Let's take a look at happen when we compute return on equity under return on equity 9 it's going to be 9.07. Hold on a second. It's higher than the Higher than to know that of course. It's higher. Why because When we make the profit when we make the profit when we make this net profit 5.4 million What's going to happen in the prior example? We're sharing it with more shareholders Now we're only sharing it in a proportion of 60 percent. Remember this company this company this senior you hear some debt 60 40 so they have 40 percent 40 percent is financed with debt. So now the net profit is going to the shareholders. Therefore, it's computed here net profit divided by 60 million rather than taken net profit divided by 100 million we only have 60 million in equity. So the net profit will be lower That's fine But the shareholders are happier because the return on equity is higher the return on their investment is higher return on equity. Okay, so that's a normal year. Let's take a look if we had a bad year. What would happen? Okay If we had a bad year if we had a bad year ebit is 5 ebit is 5 5 million Net profit is 4 million net profit is 4 million return on equity if we have no debt is 4 percent Let's see what happened if we had a bad year if we had a bad year net profit It's going to drop further It's going to be 1.44 because remember you have you still have to pay the 3.2 million You have to pay 3.2 million in debt Now remember it's 3.2 then you have to pay taxes so the net profit will be 1.44 and this is the formula how we came up with that Now your return on equity. It's going to be hammered Why because if you have debt and you don't have a lot of profit What's going to happen is the debt holders get their money first. So what happened now is The the debt holders they get their share first they get their money first and what's that money? That's 3.2 million. So simply put you made 4 million. You have 5 million 5 million Here's let me compute it for you. Maybe it's easy to see it um computed altogether so ebit Is ebit is 5 million then what's going to happen? You're going to deduct from ebit 3.2 You have to deduct the interest from ebit. So 3.2 5 minus 3.2 So we have 5 million minus 3.2 is 1.8 Then what's going to happen now? This is your earnings before taxes Then you're going to pay 20 taxes then you have to pay So multiply this by 20 and what you're left with 1.44 of net income net income So what happened is the the interest The bondholders ate up all the profit that you made because you had a bad year and you only made 5 million in ebit Therefore the shareholders will suffer They will suffer much more than they will suffer if they had no debt under no debt when ebit was 5 million ROE was 4% now with that ebit uh with that ROE is 2.4 so notice now ROE is affected heavily negatively by the debt Let's switch the scenario and let's assume we have a good year now scenario what would happen a good year scenario We have ebit of 15 million net profit is if no debt 12 It will be 12 million 12 million return on equity is 12 million. This is for no debt Let's see what we have if we have some debt if we have some debt Net profit will be 9.44 million. Let's do the computation And basically you have 15 As ebit earnings before interest and taxes then you will deduct 3.2 And let me just do this computation real quick and it's going to give you earnings before taxes So this is 15 minus 3.2 and that's going to be 3.2 and it's going to be 11.8 11.8. This is the interest now we have EBT earnings before taxes then we're going to multiply the taxes by 20 percent. They're going to take 2.36 and 11.8 Minus 2.36 that's going to give you 9.44 and this is the net income So this is how we come up with net income, but notice what happened here Return on equity return on equity is 15.73. Although we have the same ebit of 15 million Return on equity is much higher than if we had no debt. Well, we can compare this 15 to this no debt to 12 percent. Okay, so notice when we when we are in good years We are using lever. We are using other people's money to make more money. We are using debt We are using leverage So in good years leverage will benefit leverage will benefit the shareholders much much more But also in bad years leverage will hurt the shareholders much much more Now the key to leverage is this remember we're borrowing money at 8 percent. You have to be making more than 8 percent as long as you are making more than 8 percent You should be in good shape if you are not making more than 8 percent then you will suffer So when you borrow money, you want to make sure you Earn more than what you are borrowing. So annual sales notice for these two companies if we want to kind of And you compare them just kind of to see this annual sales ebit And our oh I for both firm are the same. So what's different between those two companies that and know that it's their Financial structure. Okay, the business risk here is is identical. What's different is their financial risk In what sense some company has that the other one has no debt Okay, although no debt and some that have the same roi They sum that roe exceeds that of no debt in normal and good years And lower in bad years when you take on that you are taking on more risk And what's going to happen? You could compute your roe simply put we're using this formula 1 minus the tax rate multiplied by roa Plus roa minus interest rate Multiplied by debt divided by equity. How much you are how much you are borrowing? And let's apply this formula to see how this work in this context Okay, and hopefully this results make sense. So again if roi exceeds the borrowing rate if you can Simply put if you want to borrow money. Okay, your roi must be greater than Your borrowing rate. So notice what happened is roi roi Here 10 is greater than 8 15 Is greater than 8 here? 5 is less than 8. So in bad years The the the company with some debt will suffer more because they're borrowing at 8% Okay, so you want to you want to earn? roa more than 8% because your cost of that is 8% also on the other hand roa is less than the interest rate paid The company will suffer the company will suffer Okay, a normal year know that has an roe of 8% which is 1 minus the tax rate or 0.8 times Times its roi of 10 percent However, some debt which borrow interest at 8% and maintain a debt to equity ratio of 2 third Which is which is 2 3rd, which is what what is 2 3rd? Let's let's just kind of to To divided by 3 is 0.667 So that they have forever. So simply put for every $2 and that they have $3 in Equity they have $3 in equity and if you really think about it 4 divided by this ratio 2 3rd will be 4 divided by 6 also is 40 million divided by 60 million So their debt to equity is 40 million in debt 60 million in equity that's their structure has an roe of 9.07 And let me show you in the formula how this all how this all fits together to find roe You will take roa, which is 8% times 10% roe plus roe minus roa times the Debt to equity ratio and if this this this this computation we find out that roe equal to 9.07 So some debt You know that makes positive contribution to roe in the scenario Why because the firms roa Exceeds the interest rate on the debt. So what the key here is this number here This number here the 10% so you want this to be higher than 8% if it's higher than 8% Which is not 8% higher than your interest borrowing grade then you should be in good shape Okay So if you like this recording, please like it and share it again I'm gonna remind you if you're a cpa candidate Check out my website farhatlectures.com for additional resources because I do explain the material and the tails And if you don't want to you know, if you don't want to check out my website for anything Check out how well is your university doing on the cpa exam? There's data of your average Passing and scores on the cpa exam overall as well as per section Good luck study hard and stay safe. Of course in the next session. I would look at economic value as