I have the following statement which can be true or false.

A company with operational rentability (EBIT/Assets) of 11% (after income tax of 30%) analyses taking debt. If the credit consists of 16% annual its ROE will increase.

Is it true or false and why? (Yes, it's an exam question) Sorry for my translation.

  • by credit I mean a loan – Someone Dec 1 '18 at 23:18

The actual question is not clear (what "credit"?), but to answer the title question -

Yes using debt to grow a business can increase ROE, because the debt will (presumably) be used to buy assets that will increase returns, but leave equity unchanged. So the ratio increases. It's called leverage in finance.

It can also decrease ROE if the cost of debt (interest) is greater then the additional earnings. In other words, the interest on the debt is costing you more than you are earning from the additional assets, so your return is lower with the same amount of equity. Generally, though, debt is "cheaper" than equity, so in most cases ROE is increased by taking on debt.

This is why it's important not to use any one financial ratio in a vacuum. You have to look at why the ratio changed, and look at other ratios to make sure that a company hasn't used too much leverage to increase ROE, since leverage works against you in bad times (gains and losses are multiplied).

  • In many languages the word for loan is very similar to the english word "credit" so I assume that's what it means – xyious Nov 28 '18 at 16:21
  • Thank you. Yes with 'credit' I meant a loan. Do you knwo which formula I should use to calculate if the ROE increases or decreases in this case? – Someone Dec 1 '18 at 23:19

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