Which statement best explains why ROE can exceed ROA?

Which statement best explains why ROE can exceed ROA?

• A. Because ROE exceeds ROA due to higher depreciation
• B. ROE can exceed ROA due to equity financing
• C. ROE can exceed ROA due to tax considerations
• D. Because financial leverage amplifies returns on equity

Answer: (D)

Financial leverage explains why ROE can exceed ROA. ROA is net income divided by total assets, while ROE is net income divided by shareholders’ equity. When a company uses debt, its assets grow, but shareholders’ equity doesn’t rise by the same amount. If the return earned on those assets is positive and exceeds the cost of that debt, net income increases and is spread over a smaller equity base. That makes ROE higher relative to ROA because the same earnings are attributed to a smaller pool of shareholders’ funds. In short, borrowing amplifies the equity return by funding assets that generate earnings, so equity-based profitability can outpace asset-based profitability.

Financial leverage explains why ROE can exceed ROA. ROA is net income divided by total assets, while ROE is net income divided by shareholders’ equity. When a company uses debt, its assets grow, but shareholders’ equity doesn’t rise by the same amount. If the return earned on those assets is positive and exceeds the cost of that debt, net income increases and is spread over a smaller equity base. That makes ROE higher relative to ROA because the same earnings are attributed to a smaller pool of shareholders’ funds. In short, borrowing amplifies the equity return by funding assets that generate earnings, so equity-based profitability can outpace asset-based profitability.