Team Member Guide

  Financial Structure Return On Equity

Leverage Is Key

From this discussion we can see that leverage is the key issue in the financial structure of the firm. We can make a few generalizations for publicly held companies.

Using stockholder’s Image as the definition, a leverage of 1.0 means the company is entirely funded by equity. Stockholders, including potential stockholders like a corporate raider, will ask, “Why can’t management borrow, invest the money, and make profits on the borrowed funds?” Management can expect trouble at a leverage of 1.0.

At a leverage of 2.0, for every dollar of equity, there is a dollar of debt. Management and bankers will be happy, although stockholders might pressure for more debt.

At a leverage of 3.0, for every dollar of equity, there are two dollars of debt. If the investments are good, stockholders will be delighted. Management and debt holders will be modestly uncomfortable.

At a leverage of 4.0, for every dollar of equity, there are three dollars of debt. Even stockholders are likely to be uncomfortable. Management will feel pressure to bring down the leverage, and are at some risk of losing their jobs if they do not.

How would applying ROE alone likely affect the balance sheet?

Management will buy assets. The assets will produce higher sales volume. The higher sales volume will increase profits. Management will minimize stock issues, and they will pay dividends to get rid of any excess (non-leveraged) retained earnings.

Assets Minimally Increased To Emphasise Roe

Cash $4,000 Accounts Payable $9,380 7.0%
Accounts Receivable $14,000 Current Debt $12,060 9.0%
Inventory $18,000 Long Term Debt $58,960 44.0%
Total Current Assets $36,000 Total Liabilities $80,400 60.0%
Plant and equipment $150,000 Common Stock $21,038 15.7%
Accum. Depreciation ($52,000) Retained Earnings $32,562 24.3%
Total Fixed Assets $98,000 Total Equity $53,600 40.0%
Total Assets $134,000 Total Liab. & O. E. $134,000 100.0%

The implications for other performance measures include:

  • ROS: Should at least stay flat, and probably improves.
  • Asset turnover: Should at least stay flat, and probably improves.
  • ROA: Should at least stay flat, and probably improves.
  • Stock price: Increases. EPS increases. Excess working capital is returned to stockholders as dividends. There are few stock issues to dilute stock.
  • Market cap: Increases as stock price goes up.
  • Cumulative profit: Increases.
  • Market share: Hard to predict. Often there is some tradeoff in the short run between profits and market share. Management is reluctant to reduce profits, but knows that increasing sales volume while holding ROS constant must increase asset turnover, and therefore improve ROA and ROE. At best, we see modest improvements in market share.

At a big picture level, assets are some multiple of equity. If equity is kept small, the asset base must be small. Therefore, in the long run, emphasis on ROE can stunt a company.