Posted on February 7, 2009 - by La Papillion

Woe be to those who missed out ROE

Photo by Bully The Bear

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.

WARNING: THIS IS ONE OF THE MOST CHEAM AND LONGEST POST I EVER DID ON ACCOUNTINGS. PROCEED WITH CAUTION.

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: Read more…

Related posts:

1. Fundamental Analysis: Balance Sheet
2. An individual as a private company
3. Balance and Reversion