Question 26a: Fire Has Destroyed A Large Percentage Of The F

Question 26a Fire Has Destroyed A Large Percentage Of The Financial

Question 26a Fire Has Destroyed A Large Percentage Of The Financial

QUESTION 26. A fire has destroyed a large percentage of the financial records of the Strongwell Co. You have the task of piecing together information in order to release a financial report. You have found the return on equity to be 13.8 percent. Sales were $979,000, the total debt ratio was 0.42, and total debt was $548,000. What is the return on assets?

Options: 6.92%, 8.00%, 8.45%, 9.03%, 9.29%

Paper For Above instruction

The scenario provided involves reconstructing financial information after a destructive event, exemplifying the importance of accurate financial analysis and understanding key financial ratios. The key parameters given include the return on equity (ROE), sales, debt ratio, and total debt, which all serve as fundamental components for calculating the return on assets (ROA). This assignment demonstrates how various financial ratios are interlinked and how they can be used to derive important performance measures such as ROA, especially in situations where some records have been lost or damaged.

The primary goal here is to calculate the company's return on assets, which indicates how efficiently a firm is using its assets to generate profit. The available information includes the return on equity (ROE) of 13.8%, sales of $979,000, total debt ratio of 0.42, and total debt of $548,000. To arrive at ROA, we need to understand the relationship between ROE, ROA, and the company's financial leverage, which is encapsulated by the equity multiplier.

Understanding the relevant financial ratios

Return on equity (ROE) is defined as net income divided by equity, expressed as a percentage. Return on assets (ROA), on the other hand, measures net income relative to total assets. These ratios are related through the equity multiplier (EM), which indicates the degree of financial leverage employed by the firm:

  • ROE = ROA × Equity Multiplier
  • Equity Multiplier = Total Assets / Total Equity

Since the debt-to-assets ratio is given, we can find the total assets using the debt ratio. The debt ratio of 0.42 implies that total debt accounts for 42% of total assets. Using total debt, we can infer total assets, and with total assets and debt figures, we can assess the firm's financial leverage to ultimately compute ROA.

Calculations

First, calculate the total assets:

Total debt = $548,000

Debt ratio = 0.42 = Total debt / Total assets

Therefore:

Total assets = Total debt / Debt ratio = $548,000 / 0.42 ≈ $1,304,762

Next, determine equity:

Total assets = Total debt + Total equity

=> Total equity = Total assets - Total debt ≈ $1,304,762 - $548,000 = $756,762

Now, find the return on equity:

ROE = 13.8% = 0.138

ROE = Net income / Equity

=> Net income = ROE × Equity ≈ 0.138 × $756,762 ≈ $104,376

Calculate the equity multiplier:

EM = Total Assets / Equity ≈ $1,304,762 / $756,762 ≈ 1.72

Finally, derive return on assets:

Using the relation ROE = ROA × EM:

=> ROA = ROE / EM ≈ 0.138 / 1.72 ≈ 0.0802, or approximately 8.02%

Conclusion

The calculated return on assets for Strongwell Co. is approximately 8.02%. Among the options provided, this corresponds most closely with the 8.00% choice. This exercise illustrates how financial leverage affects profitability ratios and demonstrates the importance of understanding the relationships between key financial metrics in reconstructing missing or damaged financial records.

References

  • Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of Corporate Finance (13th ed.). McGraw-Hill Education.
  • Ross, S. A., Westerfield, R. W., & Jaffe, J. (2019). Corporate Finance (12th ed.). McGraw-Hill Education.
  • Brigham, E. F., & Houston, J. F. (2021). Fundamentals of Financial Management (15th ed.). Cengage Learning.
  • Gitman, L. J., & Zutter, C. J. (2019). Principles of Managerial Finance (15th ed.). Pearson.
  • Palepu, K. G., Healy, P. M., & Bernard, V. L. (2019). Business Analysis & Valuation: Using Financial Statements (6th ed.). Cengage Learning.
  • Higgins, R. C. (2018). Analysis for Financial Management (12th ed.). McGraw-Hill Education.
  • Weston, J. F., & Brigham, E. F. (2020). Managerial Finance. Cengage Learning.
  • Lev, B. (2018). Intangibles: Management, Measurement, and Reporting. Brookings Institution Press.
  • Ross, S., & Westerfield, R. (2021). Fundamentals of Corporate Finance. McGraw-Hill Education.
  • Berk, J., & DeMarzo, P. (2019). Corporate Finance (5th ed.). Pearson.

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