Posted: February 18th, 2022

International Journal of Production Economics




Table of Contents

Q.1. Accounting: Critically discuss how a company can analyze and adjust its profitability. 3

Q.2 How could the financial leverage of the firm affect the return on equity of the firm?. 4

References. 6



Q.1. Accounting: Critically discuss how a company can analyze and adjust its profitability. 

Typically, a business and career owner always depends on the personal satisfaction of self-promoted pride, which eventually creates a healthy structure of accomplishment. A particular business can generate a profit margin for the time being. Based on several ownership company’s profit calculations, we can be sure of the entire profit structure. Since they first created almost every company of this type based on the goal of being their boss mentality and, of course, earning profits (Kamrad et al. 2021). Besides only calculating the bank account for profitability, we can describe three different methods as well, as follows:

Firstly, the profit ratios of the company on a monthly or quarterly basis. At some points, yearly ratios have also been calculated.

Secondly, a detailed breakdown analysis of the company’s revenues and units sold separately in most cases.

Thirdly, investments in the products of the company. Sometimes assets are counted as well.

Since there are various techniques for preparing the income and profitability of one business, if the income statement had not been prepared beforehand, then the break-even analysis of counting the profits would be the most appropriate one. As for business structure, different structures of multiple numbers are used to describe a company’s monetary statements, such as the net profit income of annual sales. For example, we can tell these profit ratios based on the following manner:

2:1, 2 to 1, 2/1, 2

The profitability ratios of a company can be followed up by four different structural ratios, such as:

  • A company’s gross profit margin ratio.

(Net sales minus the cost of product sales from the company)


  • The ratio of the company’s operating profit margin altogether.

(Operation’s profit = gross company profit minus product sales and other administrative expenses, excluding all taxes).

  • The ratio of yearly, quarterly, and monthly net profit margins.

(Operation’s profit minus any extra expenses, excluding all taxes)

  • There are various common profit margin ratios as well.

The operation’s profit structure is just a sign of mentioning the earning capacity of the company’s current structure, which includes the total monetary transactions that have been observed over time. As the cost of created products is subject to changes, the gross margin is also subject to changes from one period to another, which affects the pricing policies of the company’s goods. If the company’s operating income is not sufficient enough, the other sources of cash to consider are:

Some options for “return investments” are considered to have a good profitability ratio since they have always been measured by the company’s investment from the owners’ points of view (Kumar et al., 2021). They include: i) Capital Generation; ii) Interest; iii) Dividends; iv) Return on Financing. A good profitability ratio can be achieved by using the company’ stock price to measure return on financing, and the company’s commitment threshold to using its own capital shall be at least 20%. The latter is the difference between interest expense and earnings before taxes applied to common stockholders’ equity. The above mentioned few points, which have been explained, are categorized as various methods of evaluating the profitability of a company and can be determined by multiple factors like bank loans, outside investors, mergers of companies, and the management skills of the owners, which can be considered a source of success for the company in the long run.

Q.2 How could the firm’s financial leverage affect the firm’s return on equity? 

In understanding what the financial leverage of a firm is, one has to understand the probable not so negative relationship between the company’s return and profitability and the exact costs of the risks the company has taken over time. they can easily explain these few inter-relationships based on the returns of various investments, which create many more opportunities based on the owners’ own money or wealth. These details usually affect the return structure very easily, and these types of risk and return methodology are called capital asset pricing models, which normally determine the equity costs of the company. As there are no risks, this equity is normally measured and categorized for further measurements (Ladas, et al. 2021).

CAPM looks like an equilibrium that creates the return and unavoidable risk, and these structural assumptions are as follows:

  • Investors’ well-informed documents are maintained with efficient capital markets in general.
  • Zero securities are investments that are measured as transaction costs.
  • Negligible restrictions on each and every investment with no taxes.
  • The market situation is compared to perfect competition, as both look alike with no investor to affect the market price.
  • Basic risk and security expectations based on a one-year ownership
  • Lower-risk investments with higher-rate-of-return assumptions were preferred.
  • Assumptions of investors’ measured values

Basically, these costs of equity have been categorized by three standards:

  • The risk-free rate, which is based on the expected returns and currency cash flow.
  • Beta structures show a company’s equity return relative to the overall market and also measure systematic risk.
  • Premium risks show how the company is actually investing within the debt structure and how the investors in this scenario expect a higher return.

There are other ways to explain how the firm’s financial leverage affects the return on equity. A shortage of required funds in various business companies may suffer in the long run, but if that has been arranged in a not so practical manner, the whole setup will suffer for a long time to come (Zeidi, et al. 2021). To point out these particular situations, there are various different sources of functions such as equity, share capital, and debt that can be used in the company. However, it can be observed that each source of a company’s capital costs is different, and the capital structure balance sheets are maintained based on the company’s debts. The example above shows how funds are generated to trade capital, primarily to purchase assets and wages of the company. Since the capital structure is one of the most complex financial decisions, the company’s equity share capital does show the whole cost proportions of debt instruments. The company’s equity share capital is what that company does not have the capital to buy assets from the investor. Effective capital structure decisions provide risk, return, and value, which indicate if there is a decline in funds, total combinations of them may not be affected as the total cost of company capital, which increases the importance of capital structure studies. A reduced amount of equity reduces the risk that may affect investment returns, while a greater proportion of debt reduces the cost of capital and debt interest expenses.



Kamrad, B., Ord, K. and Schmidt, G.M., 2021. Maximizing the probability of realizing profit targets versus maximizing expected profits: A reconciliation to resolve an agency problem. International Journal of Production Economics238, p.108154.

Kumar, S., Kaushik, N. and Verma, A., 2021. Does earnings management impact firm performance? Empirical evidence from India. Afro-Asian Journal of Finance and Accounting11(4), pp.471-489.

Ladas, K., Kavadias, S. and Loch, C., 2021. Product Selling vs. Pay-Per-Use Service: A Strategic Analysis of Competing Business Models. Management Science.

Zeidi, A.R. and Makrani, K.F., 2021. The Role of Earnings Management in Theoretical Development and Improving the Efficiency of Accounting-Based Financial Distress Prediction Models.

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