Subject: FC 404 - Managerial Accounting

Question: If a firm’s ROE is low and management wants to improve it, explain how using more debt
might help.

Answer:
Return on Equity (ROE) is the ratio of a company’s net income relative to its shareholder equity (Net
Income / Shareholder’s Equity). Increasing ROE is to increase the numerator (Net Income) or decrease
the denominator (equity).

 Financing a business can either be through debt (loan/borrowing) or equity (shareholder). If a

company resorted to borrowing, it is presumed that that it will be used to buy assets that will
increase return (income). In this case, equity will remain unchanged.

To illustrate:
Company A has the following figures (before debt)

Income Statement Balance Sheet

Income 50,000.00 Assets 100,000.00
COS 30,000.00 Liabilities 0.00
S & A Expenses 10,000.00 Equity 100,000.00
Income Before Tax 10,000.00
Income Tax 3,000.00
Income After Tax 7,000.00

Company A borrowed 50,000 with 5% interest from a bank to improve its current operation.
Result of operations showed an increase of 20% in income. Assuming COS & S & A Expenses
are the same, figures now will be:

Income Statement Balance Sheet

Income 60,000.00 Assets 150,000.00
COS 30,000.00 Liabilities 50,000.00
S & A Expenses 10,000.00 Equity 100,000.00
Interest Expense 2,500.00
Income Before Tax 17,500.00
Income Tax 5,250.00
Income After Tax 12,250.00

ROE (before) = 7,000.00 / 100,000.00

= 7.00%

ROE (after) = 12,250.00 / 100,000.00

= 12.25%

 Example of decreasing the denominator: Using the figures above, wherein Company A has total
assets of 100,000.00 and net income of 7,000 and incurs a loan liability of 50,000.00. The
shareholder’s equity (assets less liabilities) will be 50,000.00 (100,000 – 50,000.00). Original ROE
of 7.00% (7,000/100,000) increases to 14.00% (7,000/50,000).