Analyzing Profitability Through Return on Stockholders’ Equity - Financial Management

We shows Drake’s return on stockholders’ equity, which is computed as 14.60 percent. If the firm were financed solely with common equity (stock), the return on stockholders’ equity would equal the return on investment. Drake’s stockholders have supplied only about 42 percent of the firm’s total capital, whereas creditors have supplied the remaining 58 percent. Because the entire 6.13 percent return on investment belongs to the stockholders (even though they only supplied 42 percent of the total capital), Drake’s return on common equity is higher than its return on investment.

To clarify how the return on stockholders’ equity is determined, a new ratio, the equity multiplier ratio, is defined as follows:

Equity multiplier = Total assets/Stockholders’ equity

Drake’s equity multiplier ratio is computed from figures found in Table as $81,890/$34,367 = 2.382 times. The industry average for the ratio is 1.89 times. Once again, it can be seen that Drake has financed a greater proportion of assets with debt than the average firm in the industry.

Return on Stockholders equity

The equity multiplier ratio may be used to show how a firm’s use of debt to finance assets affects the return on equity, as follows:

In Drake’s case the return on stockholders’ equity is 4.45 _ 1.377 _ 2.382 = 14.60 percent. Although this figure is the same as the return on equity computed directly by dividing earnings after tax by stockholders’ equity, the calculations shown illustrate more clearly how Drake managed to magnify a 6.13 percent return on total investment into a 14.60 percent return on stockholders’ equity by making more extensive use of debt financing than did the average firm in the industry. This increased use of debt has improved Drake’s return on equity but has also increased its risk—more likely resulting in a decline in Drake’s stock price relative to other, similar firms.

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