Financial leverage (FL), with the right mix of debit-equity, may positively impact return on equity (ROE). Suppose, for example, two companies A and B that have the same net income and assets but different amounts of debt.
| Financials> | Company A | Company B |
| Income statement | ||
| * Net income | $ 100,000 | $ 100,000 |
| Balance sheet | ||
| * Assets | $ 1,000,000 | $1,000,000 |
| * Liabilities | $ 300,000 | $ 500,000 |
| * Equity | $ 700,000 | $ 500,000 |
Let’s now calculate the following financial ratios: ROE, ROA, and FL for the two companies:
| Financial ratios | Company A | Company B |
| ROE= net income/equity | 100,000/700,000= 0.143 | 100,000/500,000= 0.20 |
| ROA= net income/assets | 100,000/1,000,000= 0.10 | 100,000/1,000,000= 0.10 |
| FL= assets/equity | 1,000,000/700,000= 1.428 | 1,000,000/500,000= 2 |
Company B is more leveraged than company A (FLB=2 > FLA=1.428), and thus its ROE is increased to a greater extent due to the higher level of leverage.
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