In the example for Far Horizons Company: Income statement given for 2018 Bal Sheet for 2017 and 2018 For calculating ROE, Profit margin is calculated using 2018 numbers but asset turnover and financial leverage using 2017 numbers! Is this correct? Shouldn’t we be using 2018 numbers if all values are available?
Example: Calculating ROE and SGR Given the following partial balance sheets and income statement for Far Horizons Company, calculate three components of the ROE (using the DuPont model) and the sustainable growth rate for 2018 based on beginning balance sheet values. Use a dividend payout ratio of 30%. All values are in millions of USD. Far Horizons Income Statement Income statement for fiscal year 2018
Sales $40.0 Net income $1.8
Far Horizons Balance Sheet
Balance sheet fiscal year end 2017 2018 2017 2018 Assets $30.0 $50.0 Liabilities $10.0 $20.0 Equity 20.0 30.0 Total $30.0 $50.0 Total $30.0 $50.0
Usually it is customary to use average values for the balance sheet numbers, e.g.
ROE = NI/average equity = NI/average assets * average assets/average equity = NI/sales * sales/av. assets * av. asset/av. equity = profit margin * asset turnover * financial leverage = $1.8/$40 * $40/$40 * $40/$25 = 4.5% * 1.0 * 1.6 = 7.2%
This question explicitly states “based on beginning balance sheet values”, but to me it is not clear if that only refers to SGR or also to ROE. Technically you can calculate ROE based on beginning balance sheet values (beginning 2018 values = end 2017 values), but that makes ROE even less reliable then it already is and a worse proxy for economic reality. In either case you have to use 2018 numbers for the profit margin.
Thank you.
. . . when computing ratios that mix income statement values with balance sheet values, or that mix cash flow statement values with balance sheet values.
For ratios that use only balance sheet values, it is customary to use ending values.
True. Thank you for pointing that out,