The Risks of Debt-Driven Returns on Equity

The three levers of ROE are:
- net profit margin  (achieve through operational efficiency)
- asset turnover (achieve through operational efficiency)
- financial leverage (achieve through employing high debt)

But does it matter if a company's high ROE comes from high debt and not operating efficiency?

If a company has a steady or steadily growing business, it might not matter that much.

For example, companies in the consumer-staples sector, where demand is stable, can handle fairly large debt loads with little problem.  And the judicious use of debt by such companies can be a boon to shareholders, boosting profitability without unduly increasing risk.

If a company's business is cyclical or volatile in some other way, though, watch out.

The problem is that debt comes with fixed costs in the form of interest payments.  The company has to make those interest payments every year, whether business is good or bad.

When a company increases debt, it increases its fixed costs as a percentage of total costs.

In years when business is good, a company with high fixed costs as a percentage of total costs can make for a great profitability because once those costs are covered, any additional sales the company makes fall straight to the bottom line.

When business is bad, however, the fixed costs of debt push earnings even lower.  

That is why debt is sometimes referred to as leverage:  It levers earnings, making strong earnings stronger and weak earnings weaker.

When companies in cyclical or volatile businesses have a lot of leverage, their earnings therefore become even more volatile.  

So the next time you're thinking about profitability, make the distinction between the kind that is internally generated (through operational efficiencies) and the kind that is inflated by debt (through leverage).

You can make a lot of money of stocks of companies structured like the latter, but your return is more assured with stocks of companies like the former.

Net Margin and Asset Turnover - Levers of ROE

The three levers of ROE are net margin, asset turnovers and financial leverage.

Not all the 3 levers of ROE are made equal.

The first two levers, net margin and asset turnover, are measures of how efficient a company's operations are.

Increasing net margins - which means a company is turning a larger portion of its sales into profits - will increase profitability.  

A high asset turnover, which expresses how many times a company sells, or turns over its assets, in a year is also a sign of efficiency.

The product of net margin and asset turnover is called return on assets, or ROA, and it is an excellent measure of operational profitability.

ROA = Net Profit Margin x Asset Turnover

The higher a company's ROA, the better.

Some companies emphasize high net margins to pump up their ROA; others emphasize rapid turnover.  

For example:

Coca Cola KO

Between 1994 and 1998, Coke's net margins averaged 18%.

Coke was able to leverage its strong brand name into higher prices, resulting in fat net margins.

Cott COTTF, a Canadian produce of discount, non-brand-name soda.

Cotts's average net margin was less than 5%.  

Cott, on the other hand, targeted the low end of the market with bargain prices, earning a slimmer profit margin on each sale but (hopefully) moving a lot more merchandise per unit of assets.

Cott's asset turnover during the same period was 1.7, compared with Coke's 1.1.  But that wasn't nearly enough to offset Coke's much higher net margins, and Coke's ROA of 24% trounced Cott's 4%.  

This is not to say that focusing on asset turnover at the expense of margins is always a bad thing.  

Wal-Mart WMT

Wal-Mart WMT has lower margins than most other major retailers because it emphasizes lower prices.  

But Wal-Mart also generates a higher ROA than most of these competitors because it operates so efficiently that its asset turnover is much higher.

In 1998, for example, Wal-Mart''s asset turnover was 2.8, as opposed to 1.1 for old-line retailer Sears S and 2.0 for rival discounter Dayton-Hudson DH.

Return on Assets

This measures the company's profitability, expressed as a percentage of its total assets.

Why it is important

Return on assets (ROE) measures how effectively a company has used the total assets at its disposal to generate earnings. Because the ROA formula reflects total revenue, total cost, and assets deployed, the ratio itself reflects a management's ability to generate income during the course of a given period, usually a year.

The higher the return the better the profit performance. ROA is a convenient way of comparing a company's performance with that of its competitors, although the items on which the comparison is based may not always be identical.

ROA = net income / total asset

Variation of this formula

A variation of this formula can be used to calculate return on net asset (RONA)

RONA = net income/(fixed assets + working capital)

And, on occasion, the formula will separate after-tax interest expense from net income:

ROA = (net income + interest expense) / total assets

It is therefore important to understand what each components of the formula actually represents.

TRICKS OF THE TRADE

• Some experts recommend using the net income value at the end of the given period, and the assets value from beginning of the period or an average value taken over the complete period, rather than an end-of-the-period value; otherwise, the calculation will include assets that have accumulated during the year, which can be misleading.
  
  
• While a high ratio indicates a greater return, it must still be balanced against such factors as risk, sustainability, and reinvestment in the business through development costs. Some managements will sacrifice the long-term intersts of investors in order to achieve an impressive ROA in the short term.
  
  
• A climbing return on assets usually indicates a climbing stock price, because it tells investors that a management is skilled at generating profits from the resources that a business owns.
  
  
• Acceptable ROAs vary by sector. In banking, for example, a ROA of 1% or better is considered to be the standard benchmark of superior performance.
  
  
• ROA is an effective way of measuring the efficiency of manufacturers, but can be suspect when measuring service companies, or companies whose primary assets are people.
  
  
• Other variations of the ROA formula do exist.

Return on Assets

Return on Assets

Abbreviated as ROA, refers to a measure of a firm's profitability, equal to a fiscal year's earnings divided by its total assets, expressed as a percentage.