Can you please illustrate further how the ROA [Return on Assets] was calculated in this question?”
MCQ – Return on Assets
Anderson Cable wishes to calculate their return on assets (ROA). You know that the return on equity (ROE) is 12% and that the debt ratio is 40%. What is the ROA?
C. 7.2% (correct)
Correct answer: (C) 7.2%
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Return on equity (ROA) formula= Net Income/Ave. Equity
Debt Ratio = Total Debt/Total Assets
To calculate the return on assets (ROA), we have to use both formulae:
ROA = ROE x (1 – Debt Ratio)
ROA = 12% x (1-40%)
ROA = 12% x 60%
ROA = 7.20%
How did we arrive at the formula?
First, we have to state the formula of ROA which is:
ROA = Net Income/Total Assets
Second, we have to extract the juice out of the given formula:
Net Income/Total Assets = Net Income/Equity x (1 – Debt Ratio)
Net Income/Total Assets = Net Income/Equity x (100% – Total Debt/Total Assets) -> In this case, the equity ratio is the remaining portion of the 100%.
*Remember the accounting equation: Assets = Liabilities + Equity
Net Income/Total Assets = Net Income/Equity x Equity/Total Assets -> Therefore the equation can be restated as:
Assets (100%) = Liabilities (40%) + Equity (60%)
Net Income/Total Assets = Net Income/
Equity x Equity/Assets
Net Income/Total Assets = Net Income/Total Assets
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