Return on equity is a must-know financial ratio. It explains, mathematically, the ratio of a company's net income relative to its shareholder equity.
In essence, it captures the return a company generates on capital that is owned by the shareholders.
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A company can improve its return on equity in a number of ways, but here are the five most common.
1. Use more financial leverageCompanies can finance themselves with debt and equity capital. By increasing the amount of debt capital relative to its equity capital, a company can increase its return on equity.
We'll use a (fictional) lemonade stand as an example for how the use of debt can increase a company's return on equity. I've created financial statements for this lemonade stand. The first shows a lemonade stand that is financed exclusively with equity; the second shows what happens when the company is financed by equal amounts of debt and equity.
Take particular notice of two things. First, the debt-free company earns more in after-tax profits than the second company: $13 vs. $11.05. This is due to the fact that the second company has an extra cost: pretax interest expense of $3 on its $100 of debt.
However, despite greater total profits, the first company has a lower return on equity of 6.5% compared to 11.05% for the second company. This is due to the fact that the second company has shareholder's equity of only $100 compared to $200. Thus, when you divide net income by shareholder's equity, you see that the second company has a higher ROE due to its financial leverage.
Financial leverage increases a company's return on equity so long as the after-tax cost of debt is lower than its return on equity.
2. Increase profit marginsAs profits are in the numerator of the return on equity ratio, increasing profits relative to equity increases a company's return on equity. Increasing profits does not necessarily have to come from selling more product. It can also come from increasing prices of each product sold, lowering the cost of goods sold, reducing its overhead expenses, or a combination of each.
To explain how profit margins affect return on equity, I've constructed financial statements for a lemonade stand before and after a price increase. The only difference in the financials for these companies is at the revenue line. The first records $100 in revenue; the second records $120 of revenue. Everything else is the same.
Notice that the company earns $13 in profits from $100 in sales before the price increase, resulting in 13% profit margins. The second generates $26 in profits on $120 in sales, and thus earns a profit margin of 21.7%.
The net result is that after increasing prices, which increases profits, the company earns a higher return on equity after raising prices (13%) than it did before the price increase (6.5%).
3. Improve asset turnoverAsset turnover is a measure of a company's efficiency. You can calculate it by dividing sales by the company's total assets. In general, the more sales a company produces relative to its assets, the more profitable it should be, and the higher return on equity it should earn.
To show how this can impact return on equity, I'll use the lemonade stand example once more. The first company is an inefficient operator. It has poor inventory controls, and thus it tends to carry more inventory than it can use right now. The second company is an efficient operator which carefully plans its budgeting, and buys inventory just days in advance, allowing it to use fewer total assets to generate the same amount of sales.
The lemonade stands have asset turnover ratios of 0.5 and 1.0, respectively. Not surprisingly, the second company also has a higher return on equity of 13%, compared to 6.5% for its less efficient rival.
4. Distribute idle cashThis is becoming a common problem among corporate giants, particularly those in the technology industry: idle cash in excess of what the business needs to continue operations reduces the apparent profitability of the company when measured by return on equity.
Distributing idle cash to shareholders is effectively a way to leverage a company, and boost its return on equity. To demonstrate, I'll use the lemonade stand example, with and without idle cash on the balance sheet.
The only difference in this example is how much idle cash is sitting on the balance sheet. When cash piles up on a company's balance sheet, it can drag down a company's return on equity. This is why it's very important to consider a company's financial leverage when analyzing a company's return on equity.
Even the best and most profitable businesses will generate a low return on equity if they have a lot of excess cash on their balance sheets. This is why so many cash-rich companies with low ROEs but sound business performance become the target of activist investors.
5. Lower taxesWho doesn't want to pay a lower tax rate? Most of corporate America does. And many are using tax strategies to help them reduce their tax rate.
In every example so far, I've used a 35% tax rate. Modifying it to 30%, 20%, or even 0% would obviously increase profits and return on equity in every single example. The lower the tax rate, the higher the profits, all else equal.
Today, low tax rates often artificially increase a company's return on equity. Many companies do business overseas, where they pay a lower tax rate than they would in the United States.
However, the difference is usually temporary. When and if a company brings its profits back to the U.S. to pay dividends or buy back shares, it will have to pay a tax rate that is consistent with the corporate average of roughly 35%. Be wary of American companies which have a lower tax rate than the corporate average. Their profits may be temporarily inflated by taxes they haven't paid, but will pay in the future.
The article 5 Ways to Improve Return on Equity originally appeared on Fool.com.
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