How could financing policy of a firm affect the return on equity of the firm using mathematical decomposition of return on equity

 

We know, Return on equity = Net Income / Shareholder's Equity

Multipying and dividing the right hand side with Sales

Return on equity = Net Income / Sales * Sales / Shareholder's Equity

Multipying and dividing the right hand side with Assets and replacing Net Income / Sales with Profit Margin

Return on equity = Profit Margin * Sales / Assets * Assets / Shareholder's Equity

Replacing Sales / Assets as Asset Turnover and Assets / Shareholder's Equity as Financial Leverage

Decomposed version of ROE = Profit Margin * Asset Turnover * Financial Leverage

The Return on equity is decomposed into 3 components which are Profit Margin, Asset Turnover and Financial Leverage.

With Financial Leverage as a component shows that a company with higher Debt financing will have a higher Return on equity, since, Interest payments are tax deductible. Further, higher debt financing decreases the Shareholder's equity which also leads to increase in Return on equity.

In conclusion, while Profit margin and Asset Turnover shows that profitability and efficiency of the firm increases the ROE, however, firm's Debt financing also affects the ROE in the Financial Leverage component.