Wednesday, February 04, 2009

Woe be to those who missed out ROE

I was just waiting for the bus to come when I thought more in depth about the concept of return on equities, otherwise known as ROE for short. It’s not those little things that you put onto sushi though.


ROE, usually denoted as a percentage, is defined as the net profits per equities of a company. Equity is the amount that is left when you subtract total liabilities from total assets. In this article, I’ll explore the idea of how difficulty it is to maintain a consistent ROE throughout the years. I figured out an example while waiting for the bus, so I’ll just use that one to illustrate.

Suppose Bullythebear Company (BTB for short) is opening for business. To start off the business, BTB managed to raise $150 from venture capitalist. However, because BTB still needs to buy some fixed asset to kick start the business, it’ll have to borrow $50 from the Kingpin. Being a kind soul, Kingpin do not require any interest to be paid up, so there is no interest charged on the $50. BTB will immediately have a cash/cash equivalent of $200, listed as a component under the assets column. The balance sheet will look somewhat like this:

BTB proceed to buy a piece of machinery (that can be used forever and hence do not need depreciation charges at all) that is used to produce the revenue, costing a princely sum of $120 paid up front without credit. Hence, from the cash/cash equivalent of $200, $120 of which will be used up, leaving $80 (200 – 120 = 80) left. The balance sheet looks like this:

So after the first year of business, BTB made a revenue of $100, and after all the costs and taxes involved, retains a net profit of $52. The $52 will be received immediately and will add to the initial $80 cash, hence the cash/cash equivalent will be raised from $80 to $132 (80+52 = 132). There is a corresponding entry in equity under retained earnings, which is the exact amount as the cash/cash equivalent, being $52. The balance sheet and income statement looks like this:

Let’s do some FA for the company at this present moment.

ROE is 25.74% (52/(150+52) = 25.74%).
Net margins is 52.0% (52/100 = 52%)
Financial leverage is 1.25 ((132+120)/202)
Asset turnover is 0.40 (100/(132+120))

Hey, not bad numbers at all!

Into the second year, BTB manages to raise revenue by 15%, which is pretty decent. Unfortunately, the direct and indirect costs associated with making the revenue also increases proportionately, creating a net profit of $59.80. Again, this sum is collected in full without credit and thus increases both the cash/cash equivalent and the retained earnings. The balance sheet and income statement looks like this:

Take a look at the figures now
Revenue increment: 15%
ROE is 22.84%
Net margins is 52%
Financial leverage is 1.19
Asset turnover is 0.37

Hey, the ROE drop from 25.74% in the first year to 22.84% in the second year, even though the company is pretty decent. The net margin remains the same and the revenue increase by 15%. This is the difficulties that company faces when they want to maintain their ROE – it’s not easy, especially when they hold their retained earnings in cash which is sitting there earning a miserable interest. The more the company earns, the harder it will have to work in order to maintain the same ROE because the asset base increases!

Let’s see what happens in year 3 when there is a great year for our BTB company, with revenue increasing by 29.6%. Here’s the balance sheet and income statement:

Here are the figures:
Revenue increment: 29.6%
ROE is 22.84%
Net margins is 52%
Financial leverage is 1.15
Asset turnover is 0.38

Here, the ROE is maintained at 22.84%, same as the previous year. But look what it takes to achieve this same consistent ROE feat – a revenue increment of nearly 30%. Can you see how hard it is to keep on maintaining the same ROE again and again, year after year? It takes not only good use of the retained earnings, but also great management insight to invest the excess earned every year to good use. It’s not easy at all!

Here's a few insights that I gained by doing this rather rigorous way of exploring how ROE numbers are generated:

1. ROE is very difficult to maintain. Every year, the management will have to decide on how to maintain ROE, which isn't fun at all. Holding too much cash is great, but it'll drag down the ROE. Invest more into their business - what if they can't generate the kind of returns? Management will also have to think about giving back earnings in terms of dividends, especially when they are not confident of using it wisely. The worst they can do is to invest in non-core business for the sake of expanding their empire. It'll drag down ROE, suck up precious cash, and even have to spend money to get out of it eventually.

2. This comes as a surprise actually. I knew it but never really thought hard about it. Financial leverage drops as one gets more and more asset base. This is the result of increasing the asset faster than one's borrowings. Just by retaining cash, the financial leverage ratio drops substantially.

3. I've a much better understanding of the relationships between the 3 statements found in financial reports. I used to do all these accounting in the past (I blogged it an article found here), as part of my journey to learn fundamental analysis, and I remembered I took half a day to do just a simple tracking. This one, I did it in 1 hour. Hey, practise do make prefect - just keep staring and crunching numbers for 1 full year, it'll work wonders.

4. I start to appreciate more when I see companies with high and consistent ROE. Take a look at Hongguo:

2008------19.7 (*)

* estimation based on 9M08's ROE


Anonymous said...

It's a really cool and concise post u did there! :)

With regards to your ROE, shouldn't the equation be current_year_revenue/(shareholder equity + previous_year_retained_earnings)?

This is because you are calculating returns on the previous year's capital base right?

la papillion said...


Thks for reading :) I thought nobody will bother reading :)

To answer your questions, no, the ROE isn't based on previous year's capital base. In fact, in the balance sheet, they will not even beak up the retained earnings according to the years accumulated. What they do is they will lump it all up together as one consolidated 'retained earnings' accumulated over the years.

Second thing that is wrong is that it's not revenue on the numerator. It's net profit. Revenue is how much the company earns before minusing all the costs. Net profit is after all cost are subtracted, and after tax. To be even more specific, it's net profit attributable to non-minority holders (i.e. to company's ordinary shareholders).

PanzerGrenadier said...


A concise but accurate analysis. As an accountant, I couldn't have explained it better!

It's great when non accountants pick up the numbers. Actually accounting is not that mystical, it's overcoming the initial paradigm of debit credits and the assets - liabilities = equities equation. :)

PanzerGrenadier said...

Just to add, even accountants were non-accountants once...hahaha

la papillion said...

Hey PG,

Haha, to have been praised by an trained accountant regarding this article is the greatest compliment of all - hey, thank you!

I couldn't agree with you more - once the relationship between assets, liabilities and equities are sorted out, it really does make it much easier :)

Chlorophyll Inc said...

Very interesting topic indeed! China Milk for etc can maintain their ROE for the past few years since listed, and yet they hold tons of cash in their assets. Could it be that they delibratly refuse to pay up all their liablities, just so that they can maintain this strong ROE? Beacuse the more liabilities they have, the more cash is leaked out via interest paid, this in turn lowers retained earnings , thus ROE is mainted that way ..hehe

la papillion said...

Hey akatsuki,

Hmm, it's possible. ROE is made up of 3 components, financial leverage (assets/equities), asset turnover (revenue/assets) and net margins (net profit/equities). If we multiply these 3 components, we get ROE.

This analysis, Dupont analysis of ROE, can help one to analyse what makes a ROE good (or bad). Let's take a look at the figures (based on FY08)

Financial leverage: 1.59
Net margins : 87.9%
Asset turnover : 0.19
ROE : 26.4%

I suppose you can say that the financial leverage is pretty high. But look at the net margins, it's also very high. I believe it's these two factors that makes the ROE high. If the financial leverage is only 1.0, then the ROE will be adjusted to 16.6% instead of 26.4%. Still respectable though.

la papillion said...

Hi Akatsuki,

I'm having lunch and pondering your question on whether it's true that China milk can increase their ROE by NOT paying off their liabilties using their cash/cash equivalents.

I decided to test it out. So, we already have the data for the ROE if they decided not to pay off their liabilities...which gives an ROE of 26.4%.

Let's see what happens if they use their cash/cash equivalent to pay off ALL their liabilities. I'll work on their FY08 results. This will result in two things:

1. The net profit will rise because there is no more interest charged. In the statements, 91,481k RMB will be added back to the net profit to give a new net profit of 572,088 k RMB.

2. Cash/cash equivalent will drop from the present 1,736,724 k RMB to 661,855k RMB after using it to pay for all the liabilities. Equities will thus be just the total assets, which is 1,818,649 k RMB. In other words, there's no change in equities if they pay off their debts using cash/cash equivalent or if they did not.

The new ROE if they pay off all their debts using their cash will thus be 31.5%. Compare this against 26.4%.

Thus, your statement that "Could it be that they deliberately refuse to pay up all their liabilities, just so that they can maintain this strong ROE?" is not true. Their ROE will be even higher should they wish to pay off their liabilities in full using their cash.

Of course, my calculations might be over simplified. It's essentially a multi-variate problem.

Chlorophyll Inc said...

Oh ic ic, my mistake. Cause the interest expense belongs to the P/L component, say if interest expense where to be gone, the Net profit will be higher , thus using simple caculation, the ROE will likewise be higher. Youre correct.. NAV will not change, this then result in a higher ROE. Logical... very logcial hehe

Chlorophyll Inc said...
This comment has been removed by the author.
Chlorophyll Inc said...

Hi, excuse me for imposing again ahah. I could just be right in saying this statement "refuse to pay up all their liablities, just so that they can maintain this strong ROE" the word here is maintaining, ok soo lets see if im correct.
Say in 2009 China Milk's Net profit increased quite abit beause it alrdy paid up all its debts, Ok -no interest exp. So for that FY 09 the ROE will indeed be higher then FY 08. However, if management doesn't give away all its net profit, this figure will be pump in back to OE (Owner's Equity) in the account called retained earnings, therefore with this huge figure under OE, going into FY 10, ChinaMilk must work even hard to maintain its ROE ,
Beacse their OE has increased and prediction of the same amt of net profit to be deprived from FY10 is uncertain..therefore having loans, keeps the amount of NP in check, so that is gives managment time to plan out what to do with those cash and in the same time maintain the ROE.. i think >_<

la papillion said...

Hi akatsuki,

I treat your word 'maintain' to mean this: to keep the ROE (26.4%) of FY08 constant, and not let it decrease. I've already shown in a oversimplistic way that paying off their total debts using their cash/cash equivalent actually increases their ROE. Thus if your definition of 'maintain' is 'to keep constant, and not increase or decrease', then we're on different grounds to begin with.

With regards to your reasons, I think there's a lot of hypothetical 'if's here. By saying that china milk is uncertain of their net profit, hence they don't want to pay debts so as to maintain ROE is a bit far fetched, in my opinion. Well, they could have reduced their equity by giving out dividends (which they did before), this will still increase ROE. How about selling away their livestock, so as to reduce their equity base, this will increase ROE too. How about buying back their shares? These are measures which the management can be sure of too, since they are the ones to decide.

My point is that while I do not know why the company do not wish to pay off their debts with their cash, i seriously doubt that it's used to increase their ROE. Not many pple even see ROE as an important criteria before they start investing, so they really have no vested interest in maintaining it. Of course, all this boils down to trusting the company to uphold the interests of shareholders and not squander it on frivolous pursuits.

Hey, thks for debating with me on this issue :) Keep it coming :)

Anonymous said...

ROE can be manipulated. One should not just relied on ROE alone but look at the Financial Statement for totality.

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