AIM-2-17-0007-NT

DECONSTRUCTING FINANCIAL LEVERAGE

Background Note

Abstract

This note bares the various elements that comprise financial leverage as a
business practice. It describes the nature of financial leverage, identifies its location in
the financial statements, illustrates its link to profitability, and explains how it is
affected by business cycles. It also covers the calculation and implications of the degree
of financial leverage. An enriching aspect of this note is the discussion of the Du Pont
method of financial analysis that focuses on the return on equity as a financial
performance measure and how financial leverage drives the business into a more
profitable operation. This note informs the readers of the limitations of the return on
equity, notwithstanding its usage and value.

1.0 Nature of Financial Leverage

Business organizations need funds to buy assets that are used in operating the
business. In doing so, the business resorts to two primary sources of funds: (a) the owners
(or shareholders in the case of a corporation) and (b) the creditors.

Funds sourced by the owners are referred to as equity. In a corporation, these are
in the form of shares of stocks. This process of sourcing funds from the owners is also
called equity financing. Funds provided by the creditors are called liabilities which are
usually in the form of loans and bonds. This type of fund sourcing is also called debt
financing.

The use of either debt or equity determines the entity’s capital structure, also
defined as the relative proportion between debt and equity financing. Thus, if an entity
decides to incur debt, the balance sheet structure would show both debt and equity. Since

This background note was written by Prof. Rufo R. Mendoza, PhD, CPA. Asian Institute of Management. All learning materials are
prepared solely for class discussion. This contains information gathered from secondary sources (i.e., books, journals, magazines,
newspapers, etc. and the writer’s insights based on teaching and work experience). The background note is neither designed nor
intended to illustrate the correct or incorrect management of problems or issues contained in the case.

Copyright © 2017, Asian Institute of Management, Makati City, Philippines, http://www.aim.edu. For inquiries, please contact the AIM
Knowledge Resource Center at krc@aim.edu.
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both debt and equity provide funds or capital to the firm, such structure is also called
capital structure. Capital structure can thus be seen in two ways: (a) debt ratio; and (b)
debt to equity ratio.

For instance, a company with both debt and equity would have the following
balance sheet structure:

Amount %
Assets $1,000 100
Liabilities (Debts) 400 40
Equity 600 60
Total $1,000 100

One way to look at it is to compute the debt ratio by dividing the amount of debts
by the amount of assets. This resulted in a debt ratio of 40%. The other way is to determine
the debt-equity ratio by dividing the amount of debt by the amount of equity. As shown
below, the debt-equity ratio is 66.67%.

𝐷𝑒𝑏𝑡𝑠 400
𝐷𝑒𝑏𝑡 𝑟𝑎𝑡𝑖𝑜 = 𝐴𝑠𝑠𝑒𝑡𝑠 = 1,000 = 40%

𝐷𝑒𝑏𝑡𝑠 400
𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 = = = 0.6667 𝑜𝑟 66.67%
𝐸𝑞𝑢𝑖𝑡𝑦 600

Mathematically, there is an interlocking relationship between these two ratios.

When the debt to equity ratio has already been obtained, it can be transformed into the
debt ratio using the following formula:

𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 0.6667

𝐷𝑒𝑏𝑡 𝑟𝑎𝑡𝑖𝑜 = = = 40%
1 + 𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜 1 + 0.6667

Therefore, given the debt-equity ratio of 66.67%, we can deduce that the debt ratio
is 40%.

This company with a debt ratio of 40% is into debt financing. This is also called
financial leverage because the debt acts like a lever in the sense that using it can greatly
magnify both gains and losses for the business.

Financial leverage is the use of debt financing to support income-earning

investments. Thus, financial leverage entails borrowing. And borrowing entails costs as
the business is using other people’s money (OPM). Such costs in the form of interest
decrease profit, resulting in a decrease in the earnings of the shareholders, as reflected in
the Earnings per Share (EPS). Understandably, financial leverage increases the potential
reward to shareholders but it also exposes the firm to potential financial distress.

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Obviously, borrowing entails financial risks because of the increased probability

of insolvency if the funds are not used profitably to cover the required payment for the
debts. Financial risk also entails additional variability of the EPS. Yet it could also provide
rewards since the use of borrowed funds could generate profits. Thus, borrowing could
magnify profits. In the same way, it could also magnify losses. If an entity does not borrow,
it could reduce financial risk. In doing so, it could also do away with the opportunity to
generate return. Hence, it is a matter of risk and return trade-off. Clearly, leverage extends
up to the point of profitability analysis.

It can be deduced that the more debt financing an entity uses, the higher its
financial leverage. And a high degree of financial leverage means high
borrowing (interest) payments, which negatively affects the entity’s bottom-
line and the EPS. As an entity increases its debt (and therefore, leverage), it is
also increasing its financial risk.

The use of OPM versus the use of the entity’s own money is a decision that a firm
makes. A firm should keep its optimal capital structure in mind when making a decision
to ensure any increase in debt increases the value of the firm. Therefore, financial leverage
is considered as a financial model. But because it affects the assets of the business, it has
also become a business model. Incidentally, the commitment of the entity to pay interest
on borrowed funds (financing decision) is not related to the amount generated from the
products or services produced by the assets financed (operating decision).

Leverage can also be understood as a mechanism of using fixed financial costs

to maximize returns. From a balance sheet perspective, debt is considered as fixed in value
(since interest on debt is fixed). However, equity is variable since it is residual—it is the
amount left after liabilities are deducted from assets (A-L=E), and assets value could go
up or down depending on how they are used.

While debt entails interest (which is fixed), equity entails dividends. And dividends
are also variable since they are residual—the value depends on what has been left as profit,
which is the source of dividends.

Another concept related to leverage is trading on the equity. Conceptually,

trading on the equity is premised on the context that any creditor is willing to grant loans
only when safety is provided by the owners’ equity capital. In other words, a given amount
of equity contributed by the shareholders becomes the base against which the entity could
borrow from the creditor. Thus, the entity trades on the equity that it has established
to obtain a loan. As it is, no creditor is willing to put up loans without the safety provided
by the owners themselves.

2.0 Locating Financial Leverage in the Financial Statements

Two types of data about financial leverage can be found in the financial statements:
(a) those found in the balance sheet are called balance sheet leverage, illustrated by the
accounting equation A=L+E; and (b) those found in the income statement are called
income statement leverage.

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The balance sheet leverage shows the composition of the financing sources:
debt and equity. Hence, it shows how the assets were financed by the firm. In the
illustration below (Table 1), the levered company’s assets of $1,000 were financed through
debts (40%) and equity (60%).

The income statement leverage shows the interest payment made on the debts
incurred by the firm. The levered company’s income statement shows interest expense
equivalent to 8% of the debt incurred. Obviously, interest expense reduces profit.

Table 1. Slices of the Balance Sheet and Income Statement

Unlevered Levered
Company Company
Balance Sheet Leverage

Assets $1,000 $1,000

Liabilities (Debts) 0 400
Equity 1,000 600
Total $1,000 $1,000

Income Statement Leverage

Earnings before interest and taxes (EBIT*) $200 $200

Less: Interest (8% of debt) 0 32
Earnings before taxes 200 168
Less: Taxes (30%)** 60 50.40
Net Profit 140 117.60
Outstanding shares 100 60

Profitability Measures

Earnings per share $1.40 $1.96

Return on Assets (ROA) 14% 14%
Return on Equity (ROE) 14% 19.6%
*EBIT is also known as the operating profit.
**Assume income tax rate of 30%.

3.0 Financial Leverage and Profitability Link

As earlier stated, the use of financial leverage affects the profitability of a firm. Two
measures to assess profitability are return on assets (ROA) and return on Equity (ROE).
Evidently, while leverage deals with the use of debt, it boils down to how the debt affects
the profit, hence, the use of ROA and ROE.

ROA measures the accounting profitability, or earning power, of the assets used
by the entity in its business. The formula is:

𝐸𝐵𝐼𝑇 𝑥 (1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒)

𝑅𝑂𝐴 =
𝐴𝑠𝑠𝑒𝑡𝑠

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200 𝑥 .70
𝑅𝑂𝐴 𝑓𝑜𝑟 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝐶𝑜𝑚𝑝𝑎𝑛𝑦 = = 14%
1,000

200 𝑥 .70
𝑅𝑂𝐴 𝑓𝑜𝑟 𝐿𝑒𝑣𝑒𝑟𝑒𝑑 𝐶𝑜𝑚𝑝𝑎𝑛𝑦 = = 14%
1,000

ROA must be measured using the profit before interest expense since it a way to
measure the earning power of the assets. Thus, it is necessary to exclude interest expense
as interest arises from debt financing and not from earning activities. If management
decides to finance the assets entirely with equity capital, the interest cost would be zero,
but the ability of the assets to produce the entity’s products would not be affected. In
essence, interest expense does not affect the earning power of the assets. An important
assumption of trading on the equity is that asset size remains constant while management
looks at different debt and equity financing combination.

ROE is the percentage return which the shareholders earn on their investment –
the firm’s equity financing. It is computed as:

𝑁𝑒𝑡 𝑃𝑟𝑜𝑓𝑖𝑡
𝑅𝑂𝐸 =
𝐸𝑞𝑢𝑖𝑡𝑦

140
𝑅𝑂𝐸 𝑓𝑜𝑟 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝐶𝑜𝑚𝑝𝑎𝑛𝑦 = = 14%
1,000

117.6
𝑅𝑂𝐸 𝑓𝑜𝑟 𝐿𝑒𝑣𝑒𝑟𝑒𝑑 𝐶𝑜𝑚𝑝𝑎𝑛𝑦 = = 19.6%
600

For the unlevered company, the ROA equals the ROE because the entity does not
use debt financing.

For the levered company, the ROE is higher because the assets earned more (14%)
than the use of debt of 5.6% (8% x .70). It should be noted that interest expense is tax
deductible, hence, debt can provide a tax shield. Effectively, the cost of debt is 5.6%. This
is also called after-tax cost of debt.

So, the company will increase its ROE when its ROA is higher than the cost of
debt. Hence, a ROE higher than ROA is due to an optimal use of leverage.

4.0 How Business Cycles Affect Leverage and Profitability

Businesses are affected by the economy and business revenues are affected by
business cycles. Certain businesses are more sensitive to business cycles than others.
Examples of highly cyclical business are those engaged in high technology, retail, and car
sale. Low cyclical businesses include utilities, railroads, airlines, and food.

Business is good on sunny days; but there are also rainy days. Hence, revenue and
subsequently profit could decline.

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Two situations are presented below to illustrate the effect of business cycles on the
business and its profitability.

Situation 1: If the earnings of the two companies above declined to $80, the returns would also
be changed.

Unlevered Levered
Company Company
Earnings before interest and taxes (EBIT) $80 $80
Less: Interest (8% of debt) 0 32
Earnings before taxes 80 48
Less: Taxes (30%) 24 14.4
Net Profit 56 33.60
Outstanding shares 100 60

Earnings per share $.56 $.56

Return on Assets (ROA) 80 𝑥 .70 80 𝑥 .70

𝑅𝑂𝐴 = 𝑅𝑂𝐴 =
1,000 1,000

56 56
= =
1,000 1,000

= 5.6% = 5.6%

Return on Equity (ROE) 56 33.6

𝑅𝑂𝐸 = 𝑅𝑂𝐸 =
1,000 600
= 5.6% = 5.6%

The decline in earnings from $200 to $80 resulted in a decline in both ROA and
ROE for both unlevered and levered companies. However, for the levered company, ROA
and ROE are equal because the ROA (5.6%) is equal to the cost of debt of 5.6% (8% x .70).

Table 1 Situation 1
Unlevered Levered Unlevered Levered
Company Company Company Company
ROA 14% 14% 5.6% 5.6%
ROE 14% 14.6% 5.6% 5.6%

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Situation 2: In an unfavorable situation, the earnings might drop even further as shown below.
From $80, the earnings went down to $60.

Unlevered Levered
Company Company
Earnings before interest and taxes (EBIT) $60 $60
Less: Interest (8% of debt) 0 32
Earnings before taxes 60 28
Less: Taxes (30%) 18 8.4
Net Profit 42 19.60
Outstanding shares 100 60

Earnings per share $.42 $.33

Return on Assets (ROA) 60 𝑥 .70 60 𝑥 .70

𝑅𝑂𝐴 = 𝑅𝑂𝐴 =
1,000 1,000

42 42
= =
1,000 1,000

= 4.2% = 4.2%

Return on Equity (ROE) 42 19.6

𝑅𝑂𝐸 = 𝑅𝑂𝐸 =
1,000 600
= 4.2% = 3.3%

As a result, the ROA and ROE declined further for both unlevered and levered companies.
But this time, the ROE (3.3%) of the levered company is lower that the ROA (4.2%). It appears
that leverage has an adverse effect in the profitability of the business.

Table 1 Situation 1 Situation 2

Unlevered Levered Unlevered Levered Unlevered Levered
Company Company Company Company Company Company
ROA 14% 14% 5.6% 5.6% 4.2% 4.2%
ROE 14% 14.6% 5.6% 5.6% 4.2% 3.3%

Clearly, financial leverage is a double-edged sword. First, for the levered company ROE is
lower than the ROA since the cost of debt of 5.6% is higher than the ROA of 4.2%. Second, the
ROE of the levered company is lower than the ROE of the unlevered company. Thus, the levered
company experiences unfavorable financial leverage.

From the foregoing discussions, the significant learnings can be stated as follows: (a) debt
and equity financing mixes lead to different results; and (b) If the assets can earn more than the
after-tax cost of debts, the profitability increases because of favorable financial leverage. And the
reverse situation could also occur.

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5.0 Degree of Financial Leverage

Another way to look at financial leverage is to determine its degree. The degree of
financial leverage (DFL) is defined as the percentage change in EPS resulting from a
given percentage change in EBIT. It is computed as follows:

𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑃𝑆

𝐷𝐹𝐿 =
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇

Assume that the levered company above operates at 20% increase in earnings
(EBIT), that is, from $200 to $240. As shown in the table below, the EPS increased from
$1.96 to $2.43, representing a 23.81% increase.

Alternatively, when EBIT decreases by 20% (from $200 to $160), EPS declined to
$1.49 or by 23.81%. These data can be more meaningful if the degree of financial
leverage (DFL) is computed.

20% 20%
Current
increase in decline in
Situation
EBIT EBIT
Assets 1,000 1,000 1,000
Liabilities (Debts) 400 400 400
Equity 600 600 600
Total 1,000 1,000 1,000
Earnings before interest and taxes (EBIT) 200 240 160
Less: Interest (8% of debt) 32 32 32
Earnings before taxes 168 208 128
Less: Taxes (30%) 50.4 62.4 38.4
Net Profit 117.6 145.6 89.6
Outstanding shares 60 60 60
Earnings per share 1.96 2.43 1.49

Using the formula above, the percentage change in EPS should be divided by the
percentage change in EBIT which is 20%.

The percentage change in EPS from $1.96 to $2.43 is 23.81%; while the change
from $2.43 to $1.49 is negative 23.81%. This resulted in the DFL of 1.19.

20% 20%
increase in decline in
EBIT EBIT
% Change in EPS 23.81 (23.81)
% Change in EBIT 20.00 (20.00)
DFL 1.19 1.19

The DFL of 1.19 indicates that each 1% change in EBIT will result in a 1.19%
increase in EPS in the same direction as the EBIT changes. In other words, DFL shows the
extent to which interest on debt magnifies changes in profit and even into the greater

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proportionate changes in EPS. The larger the entity’s DFL, the greater is the magnification
of EBIT changes into EPS changes.

An entity that is 100% equity financed would have a DFL of 1.0 for all levels of
EBIT. In contrast, an entity financed with some debts would have a DFL greater than 1.

Whenever the percentage change in EPS resulting from a given percentage change
in EBIT is greater than the percentage change in EBIT, financial leverage exists. This
means that whenever DFL is greater than 1, there is financial leverage—the higher the
quotient obtained, the greater the degree of financial leverage.

6.0 Financial Leverage and the Du Pont Method

The Du Pont Method of financial analysis is an integrated technique for measuring

business performance. This was developed in 1920 by DuPont Corporation, a US chemical
company. Since then it has grown to become the so-called DuPont Identity.

Du Pont is about understanding the ROE and what factors drive it. This is done by
decomposing the ROE and probing its components. It is a better way of explaining why
the firm’s ROE is higher or lower than the other firms in the industry.

Fundamentally, the DuPont method breaks ROE into its constituent pieces, which
are popular financial ratios and metrics: return on sales, asset turnover, and equity
multiplier. For this reason, the Du Pont method is oftentimes described as a three-step
calculation.

The first part of the Du Pont Identity starts with the return on sales, also called
net profit percentage or profit margin (Figure 1). This is obtained by dividing net profit by
net sales. It indicates the percentage of net profit relative to net sales. The second part
covers the asset turnover, obtained through dividing sales by assets. It reflects the
ability of the business to use the assets in generating sales. The return on sales and the
asset turnover reflect the ROA. Thus, when the return on sales is multiplied by the asset
turnover, the resulting figure is the ROA. This is proven by the fact that ROA is computed
by dividing net profit by assets. ROA reflects the use of assets to generate the best return
in terms of profit.

Figure 1. Du Pont Framework of Financial Analysis

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The Du Pont Method espouses that neither the return on sales nor the asset
turnover by itself provides an adequate measure of overall effectiveness. Return on sales
ignores the utilization of assets while the asset turnover ignores profitability on sales.
Accordingly, an improvement in the earning power will result if there is an increase in
asset turnover and an increase in the profit margin.

The third part of the Du Pont deals with the equity multiplier. This is obtained
by dividing assets by the shareholders’ equity and measures financial leverage. A high
equity multiplier indicates that a larger portion of asset financing is attributed to debt.
When the ROA is multiplied by the equity multiplier, we arrive at the ROE.

ROE is expressed as a percentage. The higher the percentage, the more efficient
the company has been in utilizing the invested capital. ROE is sensitive to leverage. When
the proceeds from debt financing can be invested at a return greater than the rate of
borrowing, ROE will increase with greater amounts of leverage.

In effect, the Du Pont method explains the following financial performance measures:

1. Operating efficiency -- measured by the return on sales

2. Asset use efficiency -- measured by the asset turnover
3. Financial leverage -- measured by the equity multiplier

If the ROE is unsatisfactory, the DuPont method helps analysts and management
locate the part of the business that is underperforming. For instance, in looking at the
operating efficiency, the analyst can determine whether costs are appropriately controlled
or sales have been generated at premium price that resulted in a relatively higher level of
profitability. In improving the operating efficiency, the management can initiate a cost and
expense analysis in the value chain or introduce new product with a higher margin or study
the effect of sales price increases.

In looking at the asset utilization, the analyst can recommend the speeding up of
collection of receivables to improve the quality of asset turnover. In examining the
financial leverage, the analyst can look at whether debts have been used heavily and, at
the same time, study alternative debt policies.

The operating efficiency and the asset utilization reflect the ROA. Consequently,
the ROA and the equity multiplier reflect the ROE. It goes without saying that the
difference between ROA and ROE (as two profitability measures) reflect the use of debt
financing which is technically within the ambit of financial leverage.

7.0 Limitations of ROE

The ROE indicates the extent of the earning power of the company as reflected in
amount of profit that is generated with the money invested by the owners or shareholders.
It tells whether a company is being efficient with the resources entrusted to its care. At
times, ROE is considered as the “mother of all ratios” as it is linked to profit maximization,
although it is not necessarily linked to the goal of maximizing the wealth of the
shareholders. While this metric can be useful, it has a few drawbacks.

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For instance, in the Du Pont method, a higher ROE is commonly interpreted as an

improved operational efficiency or a better utilization of assets or an increased financial
leverage. However, if the ROE only improves due to increased financial leverage, then the
increased equity returns are not actually a result of increased profits, and the company
may be overextending itself financially, making it a riskier investment. A company could
have massive amounts of excessive debt and still look like it is handling things well, based
on the ROE calculation. Even though the company might show a good ROE, it could be
close to crumbling because it has more debt than it can handle.

In addition, ROE does not consider risk. Financial leverage can increase the ROE
but more leverage means higher risk so increasing the ROE through leverage may not
always be good. Also, ROE does not consider the amount of invested capital. The
management might choose an option based on higher ROE even if the absolute amount of
capital invested is lesser. In effect, the value afforded to the company and the shareholders
is not maximized since the option with lesser capital investment is being chosen.

ROE data are taken from the financial statements and certain data may be
manipulated. Because the numerator in computing the ROE is the net income figure, it
can be inflated by some accounting practices. Notwithstanding the value of ROE, the
information user should probe other relevant circumstances to come up with a sound
decision.

8.0 Financial Leverage Applications

Shown below are two applications of leverage. In the first application, the ROA and
the ROE should be computed. On the other hand, the second application shows three
situations with different exposures to borrowings and how they impact profitability.

Application 1. Calculate the ROA and ROE for the companies whose data are shown below.
What accounts for the differences, if any, in the ROA and the ROE?

Company A Company B
Assets 4,000,000 4,000,000
Debt (9% interest) - 1,000,000
Equity 4,000,000 3,000,000
Total 4,000,000 4,000,000

Earnings before interest and taxes (EBIT) 500,000 500,000

Interest - 90,000
Earnings before taxes 500,000 410,000
Less: Taxes (35%) 175,000 143,500
Net Profit 325,000 266,500

Answers:
ROA 8.13 8.13
ROE 8.13 8.88

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Application 2. Presented below are different situations related to the use of debt. Your task is to
interpret the data shown in the tables below.

Leverage Factor (debt/total assets) 0% 40% 80%

Total assets 1,000,000 1,000,000 1,000,000
Debt (at 10% interest) - 400,000 800,000
Equity 1,000,000 600,000 200,000
Total liabilities and equity 1,000,000 1,000,000 1,000,000

Expected operating income (EBIT) 200,000 200,000 200,000

Interest (at 10%) - 40,000 80,000
Earnings before tax 200,000 160,000 120,000
Less: Taxes (40%) 80,000 64,000 48,000
Earnings after tax 120,000 96,000 72,000

Return on assets 12.00 12.00 12.00

Return on equity 12.00 16.00 36.00

Effect of a 25% Reduction in EBIT to $150,000

Expected operating income (EBIT) 150,000 150,000 150,000
Interest (at 10%) - 40,000 80,000
Earnings before tax 150,000 110,000 70,000
Less: Taxes (40%) 60,000 44,000 28,000
Earnings after tax 90,000 66,000 42,000

Return on assets 9.00 9.00 9.00

Return on equity 9.00 11.00 21.00

Effect of a 60% Reduction in EBIT to $80,000

Expected operating income (EBIT) 80,000 80,000 80,000
Interest (at 10%) - 40,000 80,000
Earnings before tax 80,000 40,000 -
Less: Taxes (40%) 32,000 16,000 -
Earnings after tax 48,000 24,000 -

Return on assets 4.80 4.80 4.80

Return on equity 4.80 4.00 -

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