With all the numbers displayed on a profit-oriented firm’s financial statements, everything boils down to one figure: the ROE. The ROE or Return on Equity is a ratio that measures a firm’s ability to generate net income for every peso of capital put in by investors. The ROE is computed as follows:
Net income, as some of us may know, is the number at the bottom of the income statement (and in case you didn’t know, this is why it is also referred to as the “bottom line”) while total equity is a figure in the balance sheet indicating how much capital the investor or investors have put into the company. As the general manager, we might generate a historical graph of the company’s ROE to determine if it’s making good money for its investors. We might also compare the company’s historical ROE against the historical ROE of its closest competitor. Provided, of course, that we have access to the latter. Still, ROE, by itself, only tells part of the story. It can tell whether the company is doing good or bad, but it cannot tell us the the reason. To know the latter, we have to break ROE down into its constituent ratios:
The first ratio (net income over sales) is called the return on sales (ROS) ratio. Sometimes it is also referred to as the net profit margin (NPM). We’ll use ROS for this article. The second ratio (sales over total assets) is referred to as the company’s return on assets (ROA). Finally, the third ratio (total assets over total equity) is called the equity multiplier (EM). Notice how sales in both ROS and ROA cancel out while total assets in ROA and EM also cancel out. When we do that, we are left with the original ROE equation.
The reason why we would want to expand the equation is that these three ratios can actually help us determine which part of the company is affecting the ROE. For example, ROS (net income divided by sales) is an indicator of a company’s operational efficiency or how effective the company is at controlling its cost. If we find that ROS has been decreasing over the years, then we might say that the ROE has done poorly because of decreasing operational efficiency. ROA (sales over total assets), on the other hand, is an indicator of the company’s marketing performance or how well the company is able to use its assets to generate sales. In this case, a declining ROA is a signal that the company may not have been effective in its marketing activities. Finally, the EM (total assets over total equity) is a measure of the company’s financial prudence or how well the company is able to optimise the cost of capital. For example, an EM of 1.0 would indicate that the company is relying solely on equity (a very expensive source of capital) while an EM of 3.0 and above means that the company is relying largely on debt (a cheap source of capital but too much of it puts the company at risk).
It’s important to note, however, that we should also examine these ratios when any one of them is unusually high because that could also be an indicator that there is something wrong. For example, the firm may not be catching up fast enough with a growing market or it may be relying too much on debt for financing. We also need to understand that financial analysis doesn’t stop at these four ratios. When we find something unusual or unexpected about any one of them, a wise thing to do is to break each down into more specific indicators such as other ratios not mentioned here (we might talk about some of them in the future). In some cases, further expansion of the numbers might even lead us back to the raw financial statements. You might wonder why, in such a case, we’d start with the ROE when we will end up with the original data anyway. A good answer would be that, by starting with ROE, we follow a systematic process of analysis that allows us to investigate each aspect of the company one by one. If we dive straight into the financial statements, we might become too overwhelmed to conduct a thorough analysis.
Brealey R. A., S. C. Myers and A. J. Marcus. Fundamentals of Corporate Finance. Profile in Amazon.com