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Overview
ROA and ROE – A Closer Look

In this lesson, the ROA and ROE calculations are expanded to separate the impact of two components in each of the resulting returns. Focus on the elements of the
financial statements to see how a change in one will impact ROA and ROE. This increases your understanding of the relationship between the financial statements.

Upon completion of this lesson, candidates should be able to:

Demonstrate an understanding of the factors that contribute to inconsistent definitions of “equity,” “assets,” and “return” when using ROA and ROE (2.A.3.a).

Determine the effect on return on total assets of a change in one or more elements of the financial statements (2.A.3.b).

Calculate and interpret sustainable equity growth (2.A.3.j.)

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Study Guide
ROA and ROE – A Closer Look

I. Return Ratios
A. Return on Assets (ROA) and Return on Investment (ROI) measure how well a firm uses its asset base to generate profits.
1. Both ratios are key measures of the success of chief executive officers (CEOs) and business unit leaders. These individuals are responsible for
profitability as well as investments in assets.
2. Business managers use return ratios to compare the returns generated on one investment with other potential investments.
3. Investors also use return ratios to assess profitability of a company.
4. Return on Equity (ROE) measures the amount of profit in relation to common shareholders’ equity.
B. The formulas to calculate ROA and ROE are:
1. ROA = Net Income ÷ Average Total Assets = $1,103 ÷ $11,056 = 10% Year 2 for Chicago Cereal
a. The DuPont Model is an expanded version of this basic ROA calculation.
b. ROA = (Net Income ÷ Sales) × (Sales ÷ Average Total Assets)

($1, 103 ÷ $11, 776) × ($11, 776 ÷ $11, 056) = 10%

9. 4% × 1.1 times = 10%

c. Said another way, ROA = Net Profit Margin × Total Asset Turnover
d. This breakdown allows for more detailed analysis of ROA by isolating the impact that the net profit margin has on ROA. For Chicago Cereal, it
improves ROA. This is good because the Total Asset Turnover is a very low number.
2. ROE = Net Income ÷ Average Equity = $1,103 ÷ $2,298 = 48%
a. The DuPont Model is an expanded version of this basic ROE calculation.
b. ROE = (Net Income ÷ Average Total Assets) × (Average Total Assets ÷ Average Equity)

($1, 103 ÷ $11, 056) × ($11, 056 ÷ $2, 298) = 48%

10% × 4.8times = 48%

c. Said another way, this is ROE = ROA × Financial Leverage

i. Financial Leverage = Assets ÷ Equity
d. This breakdown allows for more detailed analysis of ROE by showing the financial leverage. The ROA at 10% is increased substantially by the
financial leverage ratio at 4.8 times.
C. By using the DuPont model to calculate ROA and ROE management has more insight as to why the percentages are what they are. This information can
be used to develop plans to improve both returns by focusing on the weakest/lowest amounts.
II. Investors and managers must be careful when using the above formulas because there can be different meanings or definitions for assets, equity, and income.
Unless you have done the calculation yourself, you may not know exactly what numbers have been used to calculate the return.
A. Assets can be defined as:
1. Average total assets for a two-year time period.
2. Total assets for a specific time period.
3. Operating assets, meaning property, plant and equipment. These are the assets used to generate income.
B. Equity can be defined as:
1. Average common stockholders’ equity for a two-year time period. This is the amount that is most commonly used. Using this definition is in sync
with the Earnings per Share (EPS) calculation, which uses only common stock outstanding.
2. Common stockholders’ equity for a specific time period.
3. Total stockholders’ equity that includes both preferred and common stockholders’ equity. This definition is less frequently used.
C. Income or the return can be defined as:
1. Net income.
2. Net income minus preferred stock dividends. The deduction of preferred dividends brings the net income back to a return to common
shareholders.
3. Operating income is used to remove income taxes, other gains and losses, and the impact of interest expense on loans outstanding.
D. In all cases, the key to understanding ratios is to know what the analyst is using for the calculations and to make sure that the components of the
calculations are consistently used. If not used consistently, then comparisons to other time periods and/or competitor companies will not be valid.
III. The results of ROA and ROE calculations will be impacted by changes in the amounts of individual components on both the income statement and the balance
sheet. The following chart lists individual components or items on a financial statement. The second column shows the change in the component that will
increase ROA. The third column shows the change in the component that will increase ROE. For example, an increase in sales will increase both ROA and ROE.

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IV. It is important to recognize that ROE, in combination with the dividend payout ratio, can be used to determine the sustainable growth rate (SGR). The SGR is
the maximum rate a firm can grow at using its own revenue. Said another way, it is how much a firm can grow without having to borrow money for this growth.
The formula is:
A. SGR = ROE × (1 – Dividend Payout Ratio)
B. The assumptions behind this formula are:
1. The firm will maintain its target capital structure: debt and equity.
2. The dividend payout ratio remains the same.
3. The firm will maintain or increase its revenues.
C. Recall that Chicago Cereal's ROE for year 2 is 48% and its dividend payout ratio for the same year is 43.1%. Using these percentages, the following is the
calculation for Chicago Cereal's SGR:
1. SGR = .48 × (1 – .431)
2. SGR = .48 × .569
3. SGR = .273 or 27.3%
D. This tells us that Chicago Cereal can grow at a rate of 27.3% without having to take on new debt or sell more shares of common stock.
V. Return ratios are a valuable tool when analyzing the returns of a company. Understanding the definition of the components used will go a long way in
developing a valid analysis.

Summary
This closer look at ROA and ROE expanded the basic equations for both of these calculations. This gave the ability to evaluate the components of each equation to
determine the causes of the resulting ROA and ROE. Be sure to focus on the components of each equation to understand how the increase or decrease in one will
increase or decrease the final result. Also remember the additional use of ROE to calculate the SGR. This is an important percentage to know when managing the
company's finances.

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Slides
ROA and ROE – A Closer Look

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Flashcards
ROA and ROE – A Closer Look

1
FC.roa.roe.FC001_1709

What are return ratios used to measure?

How well a firm uses its asset base to generate profits
The amount of profit in relation to common shareholders' equity
Success of chief executive officers and business unit leaders
One investment as compared to other potential investments

2
FC.roa.roe.FC002_1709

How is the Return on Assets (ROA) Ratio calculated? ROA = Net Income ÷ Average Total Assets

3
FC.roa.roe.FC003_1709
Difficulty: N/A

How is the Return on Equity (ROE) Ratio calculated? ROE = Net Income ÷ Average Equity

4
FC.roa.roe.FC004_1709
Difficulty: N/A

How is the DuPont Model for ROA calculated? DuPont Model for ROA = (Net Income ÷ Sales) × (Sales ÷ Average Total
Assets)

5
FC.roa.roe.FC005_1709
Difficulty: N/A

How is the DuPont Model for ROE calculated? DuPont Model for ROE = (Net Income ÷ Average Total Assets) x (Average
Total Assets ÷ Average Equity)

6
FC.roa.roe.FC006_1709

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Why must investors and managers be careful when using ROA and ROE There can often be different meanings or definitions for assets, equity,
to measure return? and income. The investor or manager needs to be sure to know what
calculations are being used in order to ensure that the components in
the calculations are consistently used.

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Notes
ROA and ROE – A Closer Look

You haven’t made any notes or highlights yet.

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Test Bank Questions

ROA and ROE – A Closer Look

Question 1

2.A.3.j
ICMA.2A3.006_2110

A company has a return on equity of 18%, a return on assets of 10%, and a dividend payout ratio of 60%. The company’s sustainable equity growth rate is

*Source: Retired ICMA CMA questions.

10.8%.

7.2%.

6.0%.

4.0%.

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Question 2

2.A.3.b
roa.roe.tb.005_0220

A company is currently reviewing the most recent fiscal year’s results of operations and noted an increase in the return on assets ratio when compared to the prior
year. Which one of the following could have caused the increase?

*Source: Retired ICMA CMA Exam Questions.

Sales decreased by the same dollar amount that expenses increased.

Sales increased by the same dollar amount as expenses and total assets.

Sales remained the same and expenses and total assets decreased.

Sales remained the same and ending inventory decreased.

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Question 3

2.A.3.a
roa.roe.tb.006_2104
Return on assets (ROA) measures how well a firm uses its asset base to generate profits. While this is a key measure of the success of business leaders, the results of
the calculation can be misleading unless you know how assets have been defined. All of the following are ways that assets can be defined for use in ROA except:
Total assets for a specific time period.

Total assets net of any related liabilities.

Average total assets for a two-year time period.

Operating assets.

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Question 4

2.A.3.a
roa.roe.tb.007_2104
Both the return on assets (ROA) and return on equity (ROE) ratios compare net income to either assets or equity. Net income, sometimes referred to as the return,
may be defined in different ways in these calculations. All of the following are ways that net income can be defined except:
Net income as shown on the income statement.

Net income less preferred stock dividends.

Net income less common stock dividends.

Operating income.

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Question 5

2.A.3.j
roa.roe.tb.008_2104
The sustainable growth rate is a measure of how much a firm can grow without having to borrow money to finance its growth. All of the following are assumptions of
this formula except:
The firm will maintain or improve its ROA.

The firm will maintain its target capital structure of debt and equity.

The firm will maintain or increase its revenues.

The dividend payout ratio will remain the same.

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Question 6

2.A.3.j
roa.roe.tb.009_2104

Kelly Homegoods Manufacturer is looking to expand. The firm was advised to calculate its sustainable growth rate to see if it would need to borrow money to finance
this growth. Based on the following key information, how much growth can Kelly finance internally?

Gross Sales (in millions) $1,132

ROA 9.3%
ROE 12.8%
Dividend Payout Ratio 0.22

10.0%

7.3%

2.8%

2.0%

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Question 7

2.A.3.j
roa.roe.tb.010_2104

Lawson Mfg. is preparing for its strategic planning process. In preparation for the first meeting, the CEO asked how much the company could grow before it would
need to borrow money. The following financial data is available.

20X7 20X6
Common Stock, $1 par $ 54 $ 49
Additional Paid-in Capital 1,026 907
Retained Earnings 25,335 23,493
Net Sales 14,398 11,998
Gross Profit 7,222 5,917
Income from Operations 3,822 3,011
Income Before Taxes 3,586 2,725
Net Income 2,331 1,771
Dividend Payment 489 373
Return on Assets (ROA) 21.1% 21.7%

Using the sustainable growth rate and assuming that Lawson Mfg. will maintain its current target capital structure, how much growth can Lawson Mfg. support
without having to borrow additional money?

12.2%

7.5%

7.1%

6.1%

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Question 8

2.A.3.a
roa.roe.tb.011_2204
Which of the following is not a typical way to define “assets” when calculating return on assets?
Net assets as of a specific date.

Average total assets for a two-year period.

Total assets as of a specific date.

Operating assets as of a specific date.

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Question 9

2.A.3.b
roa.roe.tb.012_2204

Which of the following actions will result in an increase in Return on Assets (ROA)?

A Collecting accounts receivable

B Paying accounts payable
C Making a cash sale

A and C

B and C

A, B, and C

A and B

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Question 10

2.A.3.b
roa.roe.tb.013_2204

Which of the following actions will result in an increase in Return on Assets (ROA)?

A Implementing a just-in-time (JIT) inventory system

B Paying a cash dividend
C Replacing old equipment with new equipment

A, B, and C

A and C

A and B

B and C

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Question 11

2.A.3.j
roa.roe.tb.014_2204
The VFO Company has a dividend payout ratio of 30%, a Return on Asset (ROA) of 18%, and a Return on Equity (ROE) of 24%. Assuming these values stay the same in
the future, what is VFO’s Sustainable Growth Rate (SGR)?
7.2%

12.6%

5.4%

16.8%

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Question 12

2.A.3.j
roa.roe.tb.015_2204
The NUD Company has a dividend payout ratio of 40%, an ROA of 16%, and an ROE of 25%. If NUD has approved possible capital projects that will enable it to grow
by 20% in the next year, what should NUD do?
Make plans to raise external capital to fund some of the projects.

Make plans to begin all the projects as it will have sufficient internal capital to fund the projects.

Cancel some projects because of a lack of investment capital.

Make plans to raise external capital to fund all the projects.

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Question 13

2.A.3.a
roa.roe.tb.016_2210
Which of the following is not a typical way to define “income” when calculating return on assets (ROA)?
Pretax income

Net income

Net income less dividends on preferred stock

Operating income

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Question 14

2.A.3.b
roa.roe.tb.017_2210

Which of the following actions will result in a decrease in return on assets (ROA)?

A Collecting cash from customers in advance of sales

B Buying inventory for cash
C Recognizing insurance expense from prepaid insurance

A, B, and C

A and C

C only

A and B

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Question 15

2.A.3.b
roa.roe.tb.018_2210

Which of the following actions will result in a decrease in return on assets (ROA)?

A Buying inventory on credit

B Issuing common stock for cash
C Recognizing revenue from cash collected in advance of sales

A, B, and C

A and C

A and B

B only

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Question 16

2.A.3.j
roa.roe.tb.019_2210
The ZJS Company has a dividend payout ratio of 60%, an ROA of 15%, and an ROE of 26%. Assuming these values stay the same in the future, what is ZJS’s
sustainable growth rate (SGR)?
15.6%

6.0%

9.0%

10.4%

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Question 17

2.A.3.j
roa.roe.tb.020_2210
The QXH Company has a dividend payout ratio of 30%, an ROA of 18%, and an ROE of 27%. If QXH has approved possible capital projects that will enable it to grow by
18% in the next year, what should QXH do?
Make plans to begin all the projects since it will have sufficient internal capital to fund the projects as its sustainable growth rate (SGR) is 18.9%

Make plans to raise external capital to fund projects above the SGR of 8.1%

Make plans to begin all the projects since it will have sufficient internal capital to fund the projects as its SGR is 27.0%

Make plans to raise external capital to fund projects above the SGR of 12.6%

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Question 18

2.A.3.b
tb.roa.roe.001_1711
Newman Company's asset turnover increased from .45 in 20x6 to .51 in 20x7. What are two possible reasons for the increase?
Increased sales and a decrease in total assets

Decreased sales and an increase in total assets

Increased sales with a larger increase in total assets

Decreased sales with a smaller decrease in total assets

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Question 19

2.A.3.b
tb.roa.roe.002_1711
Gemini Group sold some of its major assets in 20x7 while having higher sales than in 20x6. What would be the effect on its asset turnover?
Gemini Group would see a higher asset turnover in 20x7 than in 20x6.

Gemini Group would see a lower asset turnover in 20x7 than in 20x6.

Gemini Group would see no change in its asset turnover between 20x6 and 20x7.
Gemini Group would see either an increase or a decrease in asset turnover but comparing the two years would require knowing how much sales increased in
20x7 compared to 20x6.

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Question 20

2.A.3.b
tb.roa.roe.003_1711

What were net sales for Walters Company's most recent fiscal year if asset turnover was 1.75 times based on the following information?

$647,500

$717,500

$350,000

$787,500

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Question 21

2.A.3.b
tb.roa.roe.004_1711

Financial statements from Broker Inc. indicate the company has the following balances:

What were Broker's net sales if its asset turnover is 2.25 times?

$1,719,000

$1,659,375

$1,599,750

$675,000

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Answered Question 1

2.A.3.j
ICMA.2A3.006_2110

A company has a return on equity of 18%, a return on assets of 10%, and a dividend payout ratio of 60%. The company’s sustainable equity growth rate is

*Source: Retired ICMA CMA questions.

10.8%.

7.2%.

6.0%.

4.0%.

Correct. A company’s sustainable growth rate (SGR) measures how much a company can grow without having to borrow money for this growth. In other
words, it is the amount a company can grow using the funds it generates. It is a function of the dividend payout ratio and return on equity. The assumption is
that any earnings not paid out as dividends are reinvested and earns the same return as the company’s ROE. The formula is “(1 – Dividend Payout) × ROE.”
Given the company’s dividend payout is 60% and its ROE is 18%, its SGR is 7.2% ((1 – 60%) × 18%.

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Answered Question 2

2.A.3.b
roa.roe.tb.005_0220

A company is currently reviewing the most recent fiscal year’s results of operations and noted an increase in the return on assets ratio when compared to the prior
year. Which one of the following could have caused the increase?

*Source: Retired ICMA CMA Exam Questions.

Sales decreased by the same dollar amount that expenses increased.

Sales increased by the same dollar amount as expenses and total assets.

Sales remained the same and expenses and total assets decreased.

Sales remained the same and ending inventory decreased.

Return on assets measures the amount of net income produced per dollar invested in average total assets. The formula is “Net income ÷ Average total
assets.” If sales remain the same and expenses decrease, the numerator of the formula increases. If total assets decreases, the denominator decreases. Both
of these changes result in an increase in return on assets.

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Answered Question 3

2.A.3.a
roa.roe.tb.006_2104
Return on assets (ROA) measures how well a firm uses its asset base to generate profits. While this is a key measure of the success of business leaders, the results of
the calculation can be misleading unless you know how assets have been defined. All of the following are ways that assets can be defined for use in ROA except:
Total assets for a specific time period.

Total assets net of any related liabilities.

Average total assets for a two-year time period.

Operating assets.

This answer is correct. Total assets are not adjusted by any associated liabilities that may exist. These liabilities are irrelevant to the ROA calculation.

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Answered Question 4

2.A.3.a
roa.roe.tb.007_2104
Both the return on assets (ROA) and return on equity (ROE) ratios compare net income to either assets or equity. Net income, sometimes referred to as the return,
may be defined in different ways in these calculations. All of the following are ways that net income can be defined except:
Net income as shown on the income statement.

Net income less preferred stock dividends.

Net income less common stock dividends.

Operating income.

This answer is correct. Net income is sometimes adjusted to show the return to common stockholders. Common stock dividends are a return to those
shareholders so they would not be deducted from net income.

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Answered Question 5

2.A.3.j
roa.roe.tb.008_2104
The sustainable growth rate is a measure of how much a firm can grow without having to borrow money to finance its growth. All of the following are assumptions of
this formula except:
The firm will maintain or improve its ROA.

The firm will maintain its target capital structure of debt and equity.

The firm will maintain or increase its revenues.

The dividend payout ratio will remain the same.

This answer is correct. The sustainable growth rate formula is based on ROE, not ROA.

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Answered Question 6

2.A.3.j
roa.roe.tb.009_2104

Kelly Homegoods Manufacturer is looking to expand. The firm was advised to calculate its sustainable growth rate to see if it would need to borrow money to finance
this growth. Based on the following key information, how much growth can Kelly finance internally?

Gross Sales (in millions) $1,132

ROA 9.3%
ROE 12.8%
Dividend Payout Ratio 0.22

10.0%

7.3%

2.8%

2.0%

This answer is correct. The sustainable growth rate = ROE × (1 − Dividend payout ratio) = 12.8% × (1 − 0.22) = 10%.

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Answered Question 7

2.A.3.j
roa.roe.tb.010_2104

Lawson Mfg. is preparing for its strategic planning process. In preparation for the first meeting, the CEO asked how much the company could grow before it would
need to borrow money. The following financial data is available.

20X7 20X6
Common Stock, $1 par $ 54 $ 49
Additional Paid-in Capital 1,026 907
Retained Earnings 25,335 23,493
Net Sales 14,398 11,998
Gross Profit 7,222 5,917
Income from Operations 3,822 3,011
Income Before Taxes 3,586 2,725
Net Income 2,331 1,771
Dividend Payment 489 373
Return on Assets (ROA) 21.1% 21.7%

Using the sustainable growth rate and assuming that Lawson Mfg. will maintain its current target capital structure, how much growth can Lawson Mfg. support
without having to borrow additional money?

12.2%

7.5%

7.1%

6.1%

This answer is correct. The sustainable growth rate (SGR) = ROE × (1 − Dividend payout ratio)

ROE = ROA × (Average total assets ÷ Average equity)

Average total assets can be calculated from the ROA equation.

ROA = Net income ÷ Average total assets. Rearranging the equation:

Average total assets = Net income ÷ ROA = $2,331 ÷ 21.1% = $11,047.39

Equity = Common stock + Additional paid-in capital + Retained earnings

Equity 20X7 = $54 + 1,026 + 25,335 = $26,415

Equity 20X6 = $49 + 907 + 23,493 = $24,449

Average equity = ($26,415 + 24,449) ÷ 2 = $25,432

With this information we can now calculate ROE = 21.1% × ($11,047.39 ÷ 25,432) = 0.09.

The Dividend payout ratio = Common dividends ÷ Earnings available to common stockholders = $489 ÷ 2,331 = 0.21

SGR = 0.09 × (1 − 0.21) = 7.1%

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Answered Question 8

2.A.3.a
roa.roe.tb.011_2204
Which of the following is not a typical way to define “assets” when calculating return on assets?
Net assets as of a specific date.

Average total assets for a two-year period.

Total assets as of a specific date.

Operating assets as of a specific date.

Correct. There are several different ways to define “assets” when calculating return on assets. Different measurements are used to capture different aspects
of performance. The three most common measurements are average total assets for a two-year period, total assets as of a specific date, and operating assets
as of a specific date. Net assets as of a specific date are not typically used to calculate return on assets as net assets is another term for equity.

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Answered Question 9

2.A.3.b
roa.roe.tb.012_2204

Which of the following actions will result in an increase in Return on Assets (ROA)?

A Collecting accounts receivable

B Paying accounts payable
C Making a cash sale

A and C

B and C

A, B, and C

A and B

Correct. Return on Assets (ROA) is used to assess how profitably a company uses its assets to generate net income. It is calculated as “Net Income / Average
Total Assets.” To increase ROA, net income has to increase or average total assets have to decrease. Paying accounts payable reduces total assets with no
impact on net income, resulting in an increase in ROA. Making a cash sale increases net income (revenue) and increases total assets. Since ROA is typically
less than 1 and both the numerator and denominator increase by the same amount, the net result is an increase in ROA. Collecting accounts receivable has
no impact on total assets as one asset increases (cash) and another decreases (accounts receivable). It also has no impact on net income. As a result,
collecting accounts receivable has no impact on ROA.

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Answered Question 10

2.A.3.b
roa.roe.tb.013_2204

Which of the following actions will result in an increase in Return on Assets (ROA)?

A Implementing a just-in-time (JIT) inventory system

B Paying a cash dividend
C Replacing old equipment with new equipment

A, B, and C

A and C

A and B

B and C

Correct. Return on assets (ROA) is used to assess how profitably a company uses its assets to generate net income. It is calculated as “Net Income / Average
Total Assets.” To increase ROA, net income has to increase or average total assets have to decrease. Implementing a just-in-time (JIT) inventory system is
likely to reduce inventory and total assets with no immediate impact on net income, resulting in an increase in ROA. Paying a cash dividend reduces cash and
total assets with no impact on net income, resulting in an increase in ROA. Replacing old equipment with new equipment will increase total assets. In
addition, depreciation expense will also increase because of the increase in total assets, reducing net income. Both will reduce ROA.

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Answered Question 11

2.A.3.j
roa.roe.tb.014_2204
The VFO Company has a dividend payout ratio of 30%, a Return on Asset (ROA) of 18%, and a Return on Equity (ROE) of 24%. Assuming these values stay the same in
the future, what is VFO’s Sustainable Growth Rate (SGR)?
7.2%

12.6%

5.4%

16.8%

Correct. A company’s sustainable growth rate (SGR) measures how much a company can grow without having to borrow money for this growth. In other
words, it is the amount a company can grow using the funds it generates. It is a function of the dividend payout ratio and returns on equity. The assumption
is that any earnings not paid out as dividends are reinvested and earn the same return as the company’s ROE. The formula is “(1 - Dividend Payout) × ROE.”
Given VFO’s dividend payout is 30% and its ROE is 24%, its SGR is 16.8% ((1 - 30%) × 24%).

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Answered Question 12

2.A.3.j
roa.roe.tb.015_2204
The NUD Company has a dividend payout ratio of 40%, an ROA of 16%, and an ROE of 25%. If NUD has approved possible capital projects that will enable it to grow
by 20% in the next year, what should NUD do?
Make plans to raise external capital to fund some of the projects.

Make plans to begin all the projects as it will have sufficient internal capital to fund the projects.

Cancel some projects because of a lack of investment capital.

Make plans to raise external capital to fund all the projects.

Correct. A company’s sustainable growth rate (SGR) measures how much a company can grow without having to raise external capital. In other words, it is
the amount a company can grow using the funds it generates. It is a function of the dividend payout ratio and returns on equity. The assumption is that any
earnings not paid out as dividends are reinvested and earn the same return as the company’s ROE. The formula is “(1 - Dividend Payout) × ROE.” Given NUD’s
dividend payout is 40% and its ROE is 25%, its SGR is 15% ((1 - 40%) × 25%). This means that NUD can grow by 15% without raising external capital. To grow
by more than 15%, it will need to raise external capital (debt or equity).

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Answered Question 13

2.A.3.a
roa.roe.tb.016_2210
Which of the following is not a typical way to define “income” when calculating return on assets (ROA)?
Pretax income

Net income

Net income less dividends on preferred stock

Operating income

Correct. There are different ways to define “income” when calculating return on assets. Different measurements are used to capture different aspects of
performance. The three most common measurements are net income, net income less dividends on preferred stock, and operating income. Pretax income is
not typically used to calculate return on assets as removing only the impact of taxes from net income does not result in a more meaningful income
measurement for ROA.

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Answered Question 14

2.A.3.b
roa.roe.tb.017_2210

Which of the following actions will result in a decrease in return on assets (ROA)?

A Collecting cash from customers in advance of sales

B Buying inventory for cash
C Recognizing insurance expense from prepaid insurance

A, B, and C

A and C

C only

A and B

Correct. ROA is used to assess how profitably a company uses its assets to generate net income. It is calculated as “Net income ÷ Average total assets.” ROA
decreases if net income decreases or average total assets increases. Collecting cash from customers in advance of sales increases total assets (cash) with no
impact on net income, resulting in a decrease in ROA. Recognizing insurance expense from prepaid insurance decreases net income and total assets. Since
ROA is typically less than 1 and both the numerator and denominator decrease by the same amount, the net result is a decrease in ROA. Buying inventory for
cash has no impact on total assets as one asset increases (inventory) and another decreases (cash). It also has no impact on net income. As a result, buying
inventory for cash has no impact on ROA.

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Answered Question 15

2.A.3.b
roa.roe.tb.018_2210

Which of the following actions will result in a decrease in return on assets (ROA)?

A Buying inventory on credit

B Issuing common stock for cash
C Recognizing revenue from cash collected in advance of sales

A, B, and C

A and C

A and B

B only

Correct. ROA is used to assess how profitably a company uses its assets to generate net income. It is calculated as “Net income ÷ Average total assets.” ROA
decreases if net income decreases or average total assets increases. Buying inventory on credit increases total assets (inventory) with no impact on net
income, resulting in a decrease in ROA. Issuing common stock for cash increases total assets (cash) with no impact on net income, resulting in a decrease in
ROA. Recognizing revenue from cash collected in advance of sales increases net income with no impact on total assets, resulting in an increase in ROA.

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Answered Question 16

2.A.3.j
roa.roe.tb.019_2210
The ZJS Company has a dividend payout ratio of 60%, an ROA of 15%, and an ROE of 26%. Assuming these values stay the same in the future, what is ZJS’s
sustainable growth rate (SGR)?
15.6%

6.0%

9.0%

10.4%

Correct. A company’s sustainable growth rate measures how much a company can grow without having to borrow money for this growth. In other words, it is
the amount a company can grow using the funds it generates. It is a function of the dividend payout ratio and return on equity. The assumption is that any
earnings not paid out as dividends are reinvested and earn the same return as the company’s ROE. The formula is “(1 − Dividend payout) × ROE.” Given ZJS’s
dividend payout is 60% and its ROE is 26%, its SGR is 10.4% ((1 − 60%) × 26%).

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Answered Question 17

2.A.3.j
roa.roe.tb.020_2210
The QXH Company has a dividend payout ratio of 30%, an ROA of 18%, and an ROE of 27%. If QXH has approved possible capital projects that will enable it to grow by
18% in the next year, what should QXH do?
Make plans to begin all the projects since it will have sufficient internal capital to fund the projects as its sustainable growth rate (SGR) is 18.9%

Make plans to raise external capital to fund projects above the SGR of 8.1%

Make plans to begin all the projects since it will have sufficient internal capital to fund the projects as its SGR is 27.0%

Make plans to raise external capital to fund projects above the SGR of 12.6%

Correct. A company’s SGR measures how much a company can grow without having to raise external capital. In other words, it is the amount a company can
grow using the funds it generates. It is a function of the dividend payout ratio and return on equity. The assumption is that any earnings not paid out as
dividends are reinvested and earn the same return as the company’s ROE. The formula is “(1 − Dividend payout) × ROE.” Given QXH’s dividend payout is 30%
and its ROE is 27%, its SGR is 18.9% ((1 − 30%) × 27%). This means that QXH can grow by 18.9% without raising external capital. Therefore, it has sufficient
internal capital to fund the projects.

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Answered Question 18

2.A.3.b
tb.roa.roe.001_1711
Newman Company's asset turnover increased from .45 in 20x6 to .51 in 20x7. What are two possible reasons for the increase?
Increased sales and a decrease in total assets

Decreased sales and an increase in total assets

Increased sales with a larger increase in total assets

Decreased sales with a smaller decrease in total assets

Asset turnover measures how much sales revenue a company generates per dollar in average total assets. Higher values are generally preferred as it shows
the company is using its assets more efficiently to generate sales. It is defined as Net Sales ÷ Average Total Assets. Increasing sales by itself (assuming total
assets stays the same) and decreasing total assets by itself (assuming sales stay the same) will result in an increase in asset turnover. This is because
increasing the numerator or decreasing the denominator of a fraction increases the fraction. Doing both together will also increase asset turnover. Therefore,
this is the correct answer.

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Answered Question 19

2.A.3.b
tb.roa.roe.002_1711
Gemini Group sold some of its major assets in 20x7 while having higher sales than in 20x6. What would be the effect on its asset turnover?
Gemini Group would see a higher asset turnover in 20x7 than in 20x6.

Gemini Group would see a lower asset turnover in 20x7 than in 20x6.

Gemini Group would see no change in its asset turnover between 20x6 and 20x7.
Gemini Group would see either an increase or a decrease in asset turnover but comparing the two years would require knowing how much sales increased in
20x7 compared to 20x6.

Asset turnover measures how much sales revenue a company generates per dollar in average total assets. Higher values are generally preferred as it shows
the company is using its assets more efficiently to generate sales. It is defined as Net Sales ÷ Average Total Assets. Increasing sales and decreasing total
assets will result in an increase in asset turnover. This is because increasing the numerator and decreasing the denominator of a fraction increases the
fraction. Therefore, this is the correct answer.

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Answered Question 20

2.A.3.b
tb.roa.roe.003_1711

What were net sales for Walters Company's most recent fiscal year if asset turnover was 1.75 times based on the following information?

$647,500

$717,500

$350,000

$787,500

Asset turnover measures how much sales revenue a company generates per dollar in average total assets. Higher values are generally preferred as it shows
the company is using its assets more efficiently to generate sales. It is defined as Net Sales ÷ Average Total Assets. Rearranging the formula results in net
sales being equal to Asset Turnover × Average Total Assets. Walters’ average total assets is $410,000 [($450,000 + $370,000) ÷ 2]. This results in Walters having
net sales of $717,500 (1.75 × $410,000). Therefore, this is the correct answer.

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Answered Question 21

2.A.3.b
tb.roa.roe.004_1711

Financial statements from Broker Inc. indicate the company has the following balances:

What were Broker's net sales if its asset turnover is 2.25 times?

$1,719,000

$1,659,375

$1,599,750

$675,000

Asset turnover measures how much sales revenue a company generates per dollar in average total assets. Higher values are generally preferred as it shows
the company is using its assets more efficiently to generate sales. It is defined as Net Sales ÷ Average Total Assets. Rearranging the formula results in net
sales being equal to Asset Turnover × Average Total Assets. Broker's average total assets is $737,500 [($764,000 + $711,000) ÷ 2]. This results in Broker having
net sales of $1,659,375 (2.25 × $737,500). Therefore, this is the correct answer.

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