Question

Explain how return on asset could decline, given an increase in net profit margin?

Answer 1

Net profit margin = Net Income / Sales

Return on Assets = Net Income / Total Assets

Net profit margin increases with increased net income relative to sales. Under normal circumstances, an increasing net profit margin should also lead to increased Return on Assets. However, if the denominator increases, i.e, if there is an increase in total assets, return on assets could decline. This could happen due to the following reasons:

• The company is going for expansion. An expansion would entail adding both fixed and current assets, and the denominator would increase.
• There is accumulation of slow moving inventories.
• The accounts receivables are not being collected promptly.