Which ratio explains the difference between return on assets and return on equity?

The correct answer is financial leverage, which plays a crucial role in differentiating return on assets (ROA) and return on equity (ROE). Financial leverage reflects the extent to which a company uses debt to finance its operations.

When a company employs debt, it can amplify its ROE compared to its ROA. This happens because ROA measures how efficiently a company utilizes its assets to generate earnings, regardless of how those assets are financed. On the other hand, ROE assesses the returns generated on the equity invested by shareholders. When a firm uses debt, it effectively increases its potential return on equity, as the profit generated from assets financed through debt contributes to equity holders, thus inflating the ROE in comparison to ROA.

The other options provided do not directly relate to the relationship between ROA and ROE in this context. For instance, the debt to equity ratio specifically measures the proportion of debt and equity funding used by a company but does not clarify the operational efficiency or profitability metrics themselves. The asset turnover ratio focuses on how effectively a company utilizes its assets to generate sales, which is separate from evaluating returns on equity versus assets. The equity multiplier, while it includes debt in its calculation of financial leverage, serves as a tool