Question

Front Beam Lighting Company has the following ratios compared to its industry for last year:

	Front Beam Lighting	Industry
Return on assets	12%	5%
Return on equity	16%	20%

Explain why the return-on-equity ratio is so much less favorable than the return on-assets ratio compared to the industry. No numbers are necessary; a one- sentence answer is all that is required.

Short answer

Because Front Beam has a lower debt/total assets ratio than the industry.

Step-by-step solution

Return on asset

Return on assets is computed by dividing the net income by the company's total assets.It shows the profitability of the company in relation to its total assets of the company.

Return on equity

Per the Dupont analysis, return on equity is computed as follows:

$Returnonasset=Returnonequity\times \left(1-\frac{Debt}{Asset}\right)$

If the debt-asset ratio is less, the return on equity is also less and vice-versa

FrontBeam's Debt/Asset Ratio

$\frac{\mathrm{Debt}}{\mathrm{Asset}}=1-\frac{ReturnonAsset}{ReturnonEquity}=1-\frac{12\%}{16\%}=0.25=25\%$

Industry's Debt/Asset Ratio

$\frac{\mathrm{Debt}}{\mathrm{Asset}}=1-\frac{ReturnonAsset}{ReturnonEquity}=1-\frac{5\%}{20\%}=0.75=75\%$