Return on Equity and Financial Leverage in Financial Analysis

Equity shareholders are the owners of a company. They enjoy the residual profit, after all the other stakeholders are rewarded for their investment. 

In the upcoming video, you will learn how to measure the return on the investment made by the equity shareholders.

Note: EAT is Earnings After Tax.

As you learnt in this video, shareholders are interested in evaluating the net income generated  per unit of equity investment, which can be calculated using the following formula:

$Returnonequity=\frac{Netincome}{Owner{s}^{\prime }equity}$

In order to analyse the performance of a company, it is important to benchmark the RoE of the company across multiple years and against its competitors. 

The RoE of a company is highly related to the operations of the company. RoE can be increased in the following cases:

If you borrow more, the net income will decrease, and if you borrow less, the owner's equity will increase. Hence, there is a need to find an optimum point between the percentage of debt that you want to borrow and the interest rate on this debt. You need to operate near the optimum point.

You also learnt about the following factors that are multiplied with the RoCE to arrive at the RoE:

The equation above reveals the following:

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Transcript of the Video: 

We now have a clear view on how to measure the performance from the operations. But let's have
a look at the performance from shareholders' point of view.

What is the question shareholders are likely to raise in order to challenge the performance
achieved by a company? What would they be interested in knowing?
Probably how much net income was generated out of the owner's equity that belongs to them
though, that would be the measure of return on equity.

Net income, 2,200 in our case, divided by owner's equity, 9,800 in our case. That leads to a return
on equity of 22.4%, whatever the number is.
What is interesting is to benchmark it against competition and to see how it evolves over time. It's
always the same story.

We now know how to measure the return to shareholders. But we previously said that, of course,
there is a close link between the performance delivered by the operations and the performance
delivered in the end to the shareholders.

Intuitively, the better the operations, the day-to-day business is performing, the higher the return
on equity to the shareholders in the end.

So, for one second, let's put ourselves in the shoes of the CFO of the company and let's ask
ourselves, look, the operations have done a very good job so far.

They've delivered an outstanding RoCE. So, assume the operating income is fixed and the capital
employed or the invested capital is fixed as well.

That's what the operations have done for us. Now we as finance people are in charge of trying to
multiply this performance to deliver an even better return to the shareholders in the end.
We want to leverage the operating performance so as to max up the return on equity. So typically,
we want the highest net income possible if we want to max up the return on equity.
So, if we assume the operating income is fixed, but we want the highest net income possible, what
shall we do?

Well if we look at the income statement structure, we can see that we need to minimise the
interest expenses.

How are we going to achieve that? Well, negotiate as low as possible an interest rate with our
banker, for example, or borrow as little debt as possible. These are the good ideas to minimise the
interest expenses.

Next, we have to minimise taxes. So, we can do a bit of tax optimisation if allowed. But at the end
of the day, we always have to pay our taxes, accept to pay the regulatory taxes.
So, that one, we can't do much about it. What's next? If we want to max up the return on equity,
the second big idea is to minimise the denominator in that ratio, minimise the owner's equity.
So, where is owner's equity? It is in the invested capital. If operating people tell me they need
$16,000 to run the business and I want as low as possible an owner's equity, then it means I have
to borrow more money from banks.

So, what did we say? We want to minimise the interest rate, but we want to maximise the bearings
from banks.

Can these two things go together well? We need to be careful because the more we borrow from
the bank, the higher the risk perceived by the banker, and the more likely he or she is to charge
higher interest rates.

So, altogether, their must be an optimum to find between the percentage of debt we're borrowing
and the interest rate we are charged by the banker.

And that's what finance people are in charge of. Play around what we call the financial leverage in
order to boost the final performance delivered to the shareholders.

And how do they do that? By optimising the proportion of debt and the cost of debt at the same
time.

Maybe we can have a look at that with formulas to fix the ideas. See we start from a certain return
on capital employed. This one is fixed.

That's what's operating people have delivered for us. And what is the goal? We want to max up
the return on equity.

So, how can we move from RoCE to ROE? Let's play around the items here, multiply, divide by
the same numbers here and there.

Arrange all the terms and that's where we get to. And what's next, two factors that help us truly
manage to multiply the operating performance.

These are financial tools to multiply the operating performance. And that's what we call the
financial leverage.

The first factor mimics how low the interest rate is. The second factor mimics how strong the
proportion of debt is within the total capital employed.

If we play well on these two factors, we can get to multiplying the operating performance.
Let's not forget that taxes are going to reduce a bit the performance achieved, and this is how we
get to a certain level of ROE. So, that's in a nutshell what the financial leverage is about.
The financial leverage is taken care of by finance people who essentially take the operating
performance for granted and try to leverage it in order to deliver an even higher return on equity to
shareholders in the end.