Question

The following ratios relate to an entity’s financial situation compared with that of its industry: The Industry Entity Average Return on assets (ROA) 7.9% 9.2% Return on equity (ROE) 15.2% 12.9% What conclusion could a financial analyst validly draw from these ratios?

Answer 1

Answer:

The entity is financially stronger performance wise than the industry as a whole although both contribute towards the shareholder's wealth.

Explanation:

Average Return on Assets (ROA) = Profit After Tax (PAT)            *    100

                                                                Average total assets

Average Total Assets = ( Total Assets at beginning of the accounting period + Total  Assets at the end of the accounting period) / 2

Return on Equity (ROE) = Dividend                     * 100

                                           Equity share capital

                                Industry                                       Entity

ROA                              7.9%                                            9.2%

ROE                             15.2%                                          12.9%

The financial performance of the entity is stronger than the industry, as it's generating greater profits after tax as compared to the whole industry on its average total assets although the dividend payout to the shareholders is less of the entity as compared to the industry as a whole. It's to be noted that dividend is paid out of Profits After Tax. After paying the dividends, we are left with retained earnings, which are used for growth and expansion purposes. The entity is focusing on shareholder's wealth creation via growth and expansion route i.e. using the retained earnings as it's ROE is lower than the industry. The industry is focusing on shareholder's wealth maximization via paying dividends as it doesn't see much of the room for growth and expansion seeing the current industry environment. So, it prefers to pay dividends to its shareholders rather than sitting on idle cash.

Hence, it can be said that the entity is financially stronger performance wise than the industry as a whole although both contribute towards the shareholder's wealth.