The importance of return on equity
Return on equity is another crucial tool in your financial toolkit. Here's how you calculate it and how you use it.
We looked at return on assets in ROA, asset turnover and margins. This time it's the turn of its cousin, return on equity (ROE). These two ratios are both linked and vitally important tools. Even Warren Buffett says so, frequently stressing the importance of ROE.
While ROA shows you what a company's assets produce, it doesn't reveal the actual return on shareholders' capital. Why not?
Shareholders are the ultimate owners of a company's assets but they don't finance all of them. Lenders and creditors also provide capital.
Items such as supplies bought on credit (say 90 days), tax, or wages earned but not yet paid, are known as 'spontaneous finance'.
This is effectively interest-free capital which shareholders don't provide, just like the interest-free period on your credit card. The ROA figure is calculated before interest and tax, two costs that must be paid before shareholders receive anything at all.
So how do you calculate ROE? Easy. It's simply the net profit after tax (NPAT), which you'll find in the income statement, divided by shareholders' equity, located in the balance sheet.
A high ROA (say over 12%) generally translates into a high ROE but the reverse certainly is not always the case. Here's why.
If a company can earn more on capital than it pays in interest, it can leverage its return to shareholders through borrowing. This is the same concept as gearing into property or using a margin loan. A company with an ordinary ROA will often borrow to increase its ROE.
There's nothing wrong with this if it's done prudently. If not, it can place the company in a dangerous financial position.
Adelaide-based retailer Harris Scarfe demonstrates how high gearing can bring a company unstuck. The company's assets were producing an average, if unspectacular, return with an ROA of 8.1% - excluding dodgy profit 'adjustments' - in the year to 31 July 2000. Through high gearing (net debt-to-equity of 73%), Harris Scarfe was able to lift its ROE to an apparently respectable 12.8%.
It was this gearing that eventually led to the company's collapse. As Buffett often points out, 'to finish first, you must first finish'. In attempting to leverage returns to shareholders, management over-extended the business and sent Harris Scarfe into receivership.
So, what's an average ROE? We'd put it at around 10-12%, although most companies that have outperformed over long periods have a higher ROE than that. Some, for example, boast ROEs of above 20% and sometimes higher than 80% if they don't need much shareholder capital to operate.
Some can use significant amounts of debt (such as Westfield) while others use very little (such as Flight Centre).
Again, it's important to look behind the numbers and really understand the type of company with which you're dealing. ROE is very useful but, like all ratios, an understanding of the business and its prospects matters most in the end.
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