[fdt]

I’m using the Wiley online testbank for BEC and I can’t seem to understand how answer D is correct for the question below. The question asks for return on equity (not return on investment). Any help would be appreciated.

An investor has been given several financial ratios for a company but none of the financial reports. Which combination of ratios can be used to derive return on equity?

A: Market to book value ratio and total debt to total assets.

B: Price to earnings ratio, earnings per share, and net profit margin.

C: Price to earnings ratio and return on assets.

D: Return on sales and asset turnover.

[Joey J]

Hi FDT, this is the short (3 component) version of the Dupont Equation to calculate Return on Equity. Memorize this formula. It is the Return on Sales times the Asset Turnover times the Leverage Ratio. In other words, it is Net Income/Sales x Sales/Total Assets x Total Assets/Shareholders Equity. The algebra mathematics will reduce it to Net Income/Shareholders Equity (the Sales and Total Assets will cancel), which is the ROE. You can see that answer D provided you with two of the three components. You might be asking “what about the 3rd component?”. The answer is which of the choices gives you ratios you can use, not ALL the ratios you have to use to deduce ROE. Thus, the answer is D. That's the funny thing about accounting, finance and other certification exams. The examiners try to be a little verbally and visually tricky sometimes.

[rknight21]

FDT if you do the questions in Study mode it will give you and explaination of the answer and its what joey j wrote

[fdt]

JoeyJ, thanks very much for the detailed response. Your “what about the 3rd component?” comment is exactly what I was thinking. I knew without that third component there was no way to get to ROE. With the question asking for what combination of ratios can be used to derive ROE, I was fully expecting the answer would have to include all the necessary ratios to get to ROE. That is good to know that they sometimes have that type of question on the exam, but it does seem odd.

[fdt]

rknight21, for this particular question the solution on Wiley seemed even more confusing since it only mentions ROI and not ROE. It was all about the ‘what about the 3rd component?' that was getting me. I understand now based on Joey J's explanation.

Here was the short explanation in Wiley study mode for the question:

Answer D is correct. These two ratios comprise the simple DuPont equation.

ROI equals net operating profit divided by sales times sales divided by total assets.

[Author]

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