Ware Company has a return on assets of 15% and a return on common stockholders' equity of 10%. John Ware, the president of the company, has asked you to explain the reason for this difference. What causes the difference? How is the concept of financial leverage involved?

A return on stockholders' equity that is lower than the return on assets means that Ware Company is not successfully using borrowed funds. Return on assets measures the return to all providers of capital, whereas return on equity is concerned only with common stockholders. It appears that the company has not been able to earn an overall return that is as high as what is being paid to creditors and preferred stockholders. Leverage deals with the use of someone else's money to earn a favorable return. Presently, Ware Company is not successfully employing financial leverage.