InvestorQ : Can the ROE be used to understand the key problem areas in a company performance?
Deepa Salunkhe made post

Can the ROE be used to understand the key problem areas in a company performance?

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Juvina Maggie answered.
1 year ago

The real value of ROE analysis comes when you break up the ROE into components and try to understand the real story of the investment by looking at its components.

Let us quickly take some key numbers from the balance sheet of Infosys. It has Equity of Rs.50,736 crore, Total Assets of Rs.50,736 crore, Net Sales of Rs.47,300 crore and Net profits of Rs.12,164 crore.

The ROE works out to 12,164 crore / 50,736 crore = 23.98%

But this ROE can be broken up into three very important components and the above formula can be re-written as under:

ROE = (Net Profit/Net Sales) X (Net Sales/Total Assets) x (Total Assets/Equity)

ROE = (12,164 / 47,300) x (47,300 / 50,736) x (50,736 / 50,736)

ROE = (25.72%) X (93.23%) X (100%) = 23.98%

Let us quickly look at each of the 3 components of the ROE break-up. The first component is the net profit margin which shows how much profit the company generates as a percentage of its total sales. This gives an idea of how profitable the company’s pricing and product profile is. The second component is the efficiency ratio or the asset turnover ratio. This is where a lot of software companies face a lot of hurdle. They have a large equity which cannot be always profitably churned. The asset turnover is actually quite low for a service company and that is probably the reason why its ROE lags that of TCS. The last one is the leverage ratio. Infosys is a zero debt company and this is relevant because debt has a lower cost compared to equity and hence reduces the overall cost of capital. However, debt also has a downside risk in the sense that it can increase your solvency risk. This is something you need to be cautious about. In short, the profit margins are decent but it is not able to generate sales and profits that are commensurate with the size of its equity. That is one of the reasons why the company is consistently going for share buybacks. These buybacks offer a double benefit. On the one hand they reduce the outstanding share capital and second they are positive for most equity related ratios.

Let us now break up the ratios implicit in the ROE analysis for greater clarity

The ROE can also be looked as a combination of three ratios as above.

The first ratio in the equation is the net profit margin and is measured as the ratio of net profits to net sales and measures the profitability per unit of sales.

The second ratio in the equation is the Asset turnover ratio. This shows how efficiently the assets of the company are being churned and utilized.

The third ratio in the above equation is the Leverage Ratio. Since Infosys is a zero-debt company, it has a leverage ratio of 100%. Otherwise normally most companies will have some component of debt and hence their Leverage ratio will be greater than 100%. So the ROE can also be reinterpreted as the product of the net margin ratio, asset turnover ratio and Leverage ratio.

Why is this split important from an investor’s viewpoint?

What this split shows is that you can increase the ROE of a company by one of the 3 ways:

· Increasing the net profit margin

· Increasing the efficiency of assets utilization

· Increasing leverage

As an investor you have to be cautious of companies that are increasing their ROE by increasing leverage. This is likely to create solvency issues going ahead. The trend of these sub-ratios is very important. When the ROE is falling or rising over a period of time, split helps you to understand what is causing this ROE trend. Is it sales margins, efficiency of assets use or purely leverage?

For an investor, the ROE is one of the most important ratios when it comes to understanding the strengths and weaknesses of the company. A careful split of ROE helps you to easily pinpoint the real strengths and problem areas in the company.

How companies can also use ROE effectively?

Finally, let us look at how the companies in question can also use ROE effectively to take important business decisions. Here is what companies can do with the ROE measure.

· Most companies calculate the profitability to various business divisions to determine the contribution. Here ROE is important because the profit on capital gives an idea on where investments are required.

· ROE of business divisions is also useful from the point of capital allocation. The job of any CFO or finance manager of a company is to ensure that the capital that generates the maximum risk adjusted returns also gets the most capital allocated. That is what efficiency is all about. For determining the allocation, the ROE is a very useful measure.

· ROE is also very useful from a risk point of view. If there are 3 business divisions and the company needs to decide where they need to take risk, then what do they do. Of course, risk taking is essential in all the business divisions but the quantum of risk will be determined based on ROE. It obviously makes a lot more sense to take additional risk in the case of business divisions that are in a position to earn higher ROE. You can at least be sure that you get better incremental return on risk.

· Lastly, in the case of M&A, one can use ROE for sum of parts valuation. This gives the company the ability to project a total valuation that is much higher.