In our recent CFA level 1 question of the day, we asked candidates about the effect of a company’s asset turnover ratio on its return on equity (ROE). As seen in the poll results, there was a mix of responses, with the majority suggesting a decrease in ROE. Let’s delve deeper into the correct answer and explore why certain responses were more popular than others.

Poll Question and Response Rates

The poll question asked: “If a company’s asset turnover ratio decreases, what effect would it have on the return on equity (ROE)?” Here are the results:

• Decrease: 65%
• Increase: 13%
• No Effect: 6%
• Cannot be determined: 15%

While the majority of respondents correctly identified that a decrease in asset turnover ratio would lead to a decrease in ROE, it’s important to understand the reasoning behind this outcome. To do that, let’s first examine what the asset turnover ratio and ROE represent, and then discuss how they interact in a real-world scenario.

Understanding the Asset Turnover Ratio and ROE

The asset turnover ratio measures a company’s efficiency in using its assets to generate revenue. It is calculated by dividing total revenue by average total assets. A higher asset turnover ratio indicates that a company is generating more revenue per unit of asset, which is generally a sign of operational efficiency.

Return on equity (ROE) is a measure of a company’s profitability relative to shareholders’ equity. It reflects how effectively a company uses shareholders’ funds to generate profits. ROE is calculated by dividing net income by shareholders’ equity.

How Changes in Asset Turnover Ratio Impact ROE

Now, let’s explore a practical scenario to understand the relationship between these two metrics. Consider a retail company that sells consumer goods. If this company’s asset turnover ratio decreases, it suggests that the company is generating less revenue per unit of asset. This could be due to several reasons, such as:

• Reduced Sales: If the company’s sales decline, it naturally leads to a lower asset turnover ratio, as fewer assets are used to generate revenue.
• Excess Inventory: A build-up of unsold inventory can also lead to a lower asset turnover ratio, indicating inefficiencies in inventory management.
• Investment in Non-Revenue-Generating Assets: If the company invests in assets that do not contribute to revenue generation, the asset turnover ratio will decrease.

Assuming that other factors, such as net profit margins and financial leverage, remain constant, a decrease in the asset turnover ratio will result in a lower ROE. This is because the company’s ability to generate net income is reduced, impacting the return to shareholders.

Addressing Common Misconceptions

Given the poll results, it’s worth addressing the common wrong answers and why they might have been chosen:

• Increase (13%): Some candidates might think that reducing assets while maintaining or increasing revenue could lead to higher profitability. However, this would only be true if the reduction in assets significantly reduces costs, leading to higher profit margins. This scenario is less likely when considering typical business operations.
• No Effect (6%): This response might stem from the belief that asset turnover ratio and ROE are independent. However, ROE is inherently influenced by multiple factors, including asset turnover. A significant change in one is likely to affect the other.
• Cannot Be Determined (15%): While it’s true that other factors could affect ROE, the relationship between asset turnover and ROE generally follows a logical pattern. A decrease in asset turnover ratio tends to lead to lower ROE, assuming other factors remain constant.

The poll results demonstrate a variety of responses, but a closer look reveals that a decrease in asset turnover ratio generally leads to a decrease in ROE, assuming other factors remain constant. This knowledge is valuable for analyzing company performance and making informed investment decisions.

Have any questions or comments? Let us know! You can reply here, or email david@bestudious.io.