Return on equity (ROE) is often the single most important financial metric used in evaluating an investment or a corporation. The figure tells you how quickly the money you put at risk is growing or shrinking. Leverage, on the other hand, measures the relationship between invested and borrowed funds. Leverage has a direct, and usually significant, relationship on return on equity.
Return on Equity
Return on equity (ROE) equals profit divided by investment. If you are analyzing a corporation, divide net profit after taxes by average shareholder equity and multiply the result by 100. Average equity equals equity at the start of the period plus equity at the end of the period divided by two. A business that earned $500,000 with shareholder equity figures of $10 million and $11 million at the start and end of the year, respectively, has an ROE of $500,000 / ($10,000,000 + $11,000,000)/2) or 4.76 percent. This means the money invested in this business grew by 4.76 percent over the course of the year.
Leverage refers to debt; the higher the leverage, the greater the proportion of debt to assets. While there are a few ways to calculate the leverage ratio, dividing total assets by total shareholder equity is the best formula when relating ROE to leverage. If the ratio of assets to equity is greater than one, the company has some debt, whereas the ratio would equal exactly one if the business has no debt. If the ratio is between one and two, total debt is less than total shareholder equity. If the ratio exceeds two, the debt levels is higher than shareholder equity.
When the business has a profitable operation, leverage boosts ROE. An alternative formula for ROE is (profit / sales) x (sales / assets) x (assets / shareholders’ equity). In other words, profitability, multiplied by the sales to asset ratio, multiplied by leverage equals ROE. The relationship between leverage and ROE is linear, meaning that an increase in leverage will boost ROE by the same extent. An intuitive explanation of the formula is that the more you sell using the same invested assets, the higher your ROE. There are two ways of selling more; you either turn over your assets more often or you borrow money to boost assets.
When Things Go Awry
The problem with leverage is that it will amplify not just positive, but also negative return on equity. If you lose 1 percent per sale, the more money you borrow to boost assets and sell more, the more you will lose. Problems grow exponentially from there and go beyond what the formula suggests. Excess losses may result in banks withdrawing loans or supplier cancelling credit lines. These can result in fire sales of valuable assets such as real estate, sending the business into a downward spiral. Therefore, leverage can boost losses to a greater extent than it boosts profits.
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