Explanation

We can analyze this using the DuPont decomposition formula:

ROE = Net Profit Margin × Asset Turnover × Financial Leverage

Where:

• ROE = Return on Equity
• Net Profit Margin = Net Income / Revenue
• Asset Turnover = Revenue / Average Total Assets
• Financial Leverage = Average Total Assets / Average Shareholders' Equity

Given data:

• Company 1: ROE = 12%, Leverage = 2, Asset Turnover = 1
• Company 2: ROE = 18%, Leverage = 3, Asset Turnover = 2

Step 1: Calculate ROA for both companies ROA = Net Income / Average Total Assets = Net Profit Margin × Asset Turnover

From DuPont: ROE = ROA × Financial Leverage So, ROA = ROE / Financial Leverage

• Company 1 ROA = 12% / 2 = 6%
• Company 2 ROA = 18% / 3 = 6%

Step 2: Calculate Net Profit Margin for both companies Net Profit Margin = ROA / Asset Turnover

• Company 1 Net Profit Margin = 6% / 1 = 6%
• Company 2 Net Profit Margin = 6% / 2 = 3%

Step 3: Evaluate each option:

A. Company 2 is less efficient than Company 1.

• Incorrect. Company 2 has higher asset turnover (2 vs 1), meaning it generates more revenue per dollar of assets, which indicates higher efficiency.

B. Company 2 has a higher ROA than Company 1.

• Incorrect. Both companies have the same ROA of 6%.

C. Company 2 has a lower net profit margin than Company 1.

• Correct. Company 2 has a net profit margin of 3% compared to Company 1's 6%.

Key insights:

• Company 2 achieves higher ROE (18% vs 12%) through a combination of:
  1. Higher financial leverage (3× vs 2×)
  2. Higher asset turnover (2× vs 1×)
  3. But lower net profit margin (3% vs 6%)
• This is a classic trade-off in business strategy: Company 2 operates on thinner margins but generates more volume and uses more leverage.