Profitability and debt ratios (ROE, D/E and more)
The answer
Return on equity, or ROE, is net profit divided by shareholders' equity. It tells you how much profit the company earned on 100 rupees of owners' money.
A high ROE can come from a good business or from borrowed money. Those are opposite things, and the ratio on its own cannot tell them apart.
Why this costs you money
You screen for companies with an ROE above 25%. Two names come out. Both look excellent. You buy one. Three years later that company is in trouble and the other one is fine. Nothing in the ROE told you which was which.
Here is the reason. ROE is profit divided by equity, and there are 2 ways to make a fraction large. Raise the top of it, by running a genuinely profitable business. Or shrink the bottom of it, by funding the company with debt instead of equity.
A company that funds itself with borrowed money reports a high ROE in every good year. Its equity is small, so the profit looks large against it. This is not fraud. It is arithmetic, and it works until a bad year arrives.
When a bad year arrives the interest still has to be paid, and a small equity base absorbs losses quickly. The company that reported 28% ROE for 5 years reports a loss that removes a third of its equity in 1 year. Then the lenders ask for their money, and a company that cannot refinance is in trouble no matter how good its business is.
The number that predicted the disaster was never the ROE. It was the ratio of debt to equity, and the interest coverage, and nobody looked at them because the ROE was so good.
The second version is quieter. An investor avoids a company with an ROE of 12% because "12 is not good enough", without noticing that it carries no debt at all. A 12% return earned with no borrowing is often a better business than a 28% return earned with 3 times as much debt as equity.
How it works
Start by separating 2 different questions.
How well does this business use money? That is profitability. Can this business survive a bad year? That is solvency.
They need different ratios, and confusing them is the source of most of the damage.
Splitting ROE: the DuPont method
In the 1920s an analyst at the DuPont company noticed that ROE could be broken into parts that each mean something. That split is the most useful thing in this article.
ROE = Net margin × Asset turnover × Financial leverage
Written with the actual quantities:
ROE = (Net profit ÷ Sales) × (Sales ÷ Total assets) × (Total assets ÷ Shareholders' equity)
Multiply the 3 terms and sales cancels, assets cancel, and you are left with net profit divided by equity, which is ROE. The identity is exact. It is not an approximation.
Each term answers a different question.
Net margin — how much of each rupee of sales becomes profit. This is pricing power and cost control. A branded consumer product has a high margin. A distributor of somebody else's product has a low one.
Asset turnover — how many rupees of sales the company generates from each rupee of assets. This is efficiency. A supermarket has high turnover and thin margins. A steel plant has low turnover and, in a good year, fat margins.
Financial leverage — how many rupees of assets the company runs for each rupee of equity. This is borrowing. A leverage figure of 1 means no debt at all. A figure of 4 means 3 rupees are borrowed for every 1 of equity.
Two companies can both report an ROE of 24%.
| Company A | Company B | |
|---|---|---|
| Net margin | 20% | 4% |
| Asset turnover | 1.2 | 1.5 |
| Financial leverage | 1.0 | 4.0 |
| ROE | 24% | 24% |
Company A earns it by selling a product at a good price with no borrowing. Company B earns it by borrowing 3 rupees for every 1 of its own. The ratio is identical. The businesses are not comparable in any way.
The ratio that removes leverage
Return on capital employed, or ROCE, sidesteps the problem. It divides operating profit — profit before interest and tax — by capital employed, which is equity plus debt.
ROCE = Earnings before interest and tax ÷ (Shareholders' equity + Debt)
Because the top of the fraction is measured before interest and the bottom includes the borrowed money, ROCE measures the return the business earns on all the money it uses, wherever the money came from. Borrowing cannot inflate it.
ROCE tells you whether the business is good. ROE tells you what borrowing did to the shareholder's share of it.
The survival ratios
Four numbers, each answering a plain question.
Debt to equity (D/E) = total borrowings ÷ shareholders' equity. How much has been borrowed against the owners' money. There is no universal safe level. A software firm with a D/E of 1 is unusual. A bank with a D/E of 8 is normal.
Interest coverage = earnings before interest and tax ÷ interest expense. How many times over the company can pay its interest bill from operating profit. This is the most useful single solvency number, because it compares the obligation to the cash that services it. A coverage of 8 is comfortable. Below 2 means one poor year removes the margin for error.
Current ratio = current assets ÷ current liabilities. Can the company meet the bills due within a year using the assets that turn into cash within a year.
Quick ratio = (current assets − inventory) ÷ current liabilities. The same question with inventory removed, because unsold stock is the current asset least likely to turn into cash when you need it most.
What it tells you, and what it does not
ROE does not tell you how the equity got small. Losses shrink equity. Buybacks shrink equity. Both raise ROE. A company that lost money for 3 years can report a spectacular ROE in the fourth, because the denominator was destroyed.
ROE breaks completely at negative equity. If shareholders' equity is below zero, ROE is a negative number that means nothing. It is not a warning and it is not a compliment. The ratio simply stops working.
ROE says nothing about growth. A company can earn 30% on equity and have no way to reinvest the money at 30%. Then the high return is not compounding, it is being paid out, and the value to a shareholder is much lower than the number suggests.
Debt ratios are not comparable across industries. Lending is the business of borrowing. A bank or a non-banking financial company is leveraged by design, and applying a manufacturer's D/E rule to a lender produces nonsense. For lenders the equivalent questions are the capital adequacy ratio, the asset-liability mismatch, and the provision coverage ratio.
The decision rule
Never accept an ROE without asking which of the 3 DuPont terms produced it. And never accept a debt figure without the interest coverage beside it.
If ROE is high and leverage is close to 1, the business is genuinely profitable — check next whether the margin is durable.
If ROE is high and leverage is above 3, you are looking at a financing decision, not a business quality. Go to interest coverage before anything else.
If ROE is high and rising while equity is falling, find out why equity fell. Buybacks and losses look identical in this ratio and mean opposite things.
Unless the company is a lender, in which case none of the above applies and you need the capital adequacy ratio instead.
Try this now
Ten minutes for the first one, 3 minutes for every one after that. Do it on a single holding — the largest position you own.
- Open the company's latest annual report, or the financials tab in your app. You need 5 numbers: net profit, sales (revenue), total assets, total shareholders' equity, and total borrowings.
- Net margin = net profit ÷ sales. Write it as a percentage.
- Asset turnover = sales ÷ total assets.
- Financial leverage = total assets ÷ shareholders' equity.
- Multiply the 3. Compare the answer with the ROE your app shows. They should be close. If they are not, you have mixed consolidated and standalone figures.
- Now get 2 more numbers: earnings before interest and tax, and interest expense. Divide the first by the second. That is your interest coverage.
What you should see. You now know something about your largest holding that the single ROE number was hiding.
If the leverage term is between 1.0 and 1.5, the ROE was earned by the business. If it is above 3, most of the ROE came from borrowing, and the interest coverage you calculated in step 6 is now the most important number you own about this company.
Repeat step 4 using last year's annual report and the one before. A leverage figure that is rising while ROE is rising is the pattern that ends badly. It looks like an improving company and it is an increasingly borrowed one.
Three real cases
1. General Electric, 2008 to 2018 (United States) — ROE built on a lender For years GE was regarded as the best-managed industrial company in the world, and it reported strong returns on equity. A large share of those profits came from GE Capital, its finance arm, which borrowed heavily in short-term markets to lend long. That is a bank inside an industrial company, and it produced returns that no jet engine business could produce alone. When short-term funding markets froze in 2008, the model broke. GE's revenue fell from $181.6 billion in 2008 to $154.4 billion in 2009, and net income from $17.3 billion to $10.7 billion. On 10 April 2015 GE announced it would sell most of GE Capital. In 2017 it cut its quarterly dividend from 24 cents to 12 cents, and in 2018 from 12 cents to 1 cent. On 26 June 2018 GE was removed from the Dow Jones Industrial Average after more than a century in it. The returns were real while they lasted. They were the returns of a leveraged lender, reported as the returns of an engineering company.
2. IL&FS, September 2018 (India) — coverage, not profitability Infrastructure Leasing and Financial Services was a large Indian infrastructure finance group, rated highly by credit rating agencies until weeks before it failed. It funded long-term infrastructure projects with shorter-term borrowing. In August and September 2018 it defaulted on repayments, and the credit ratings were cut from the top grade to default within a short period. The group's consolidated debt was reported at around ₹91,000 crore. The government superseded the board in October 2018. Its reported profitability had not been the warning. The warning was in the structure: assets that pay back over 15 years, funded by borrowings that had to be repaid in months.
3. McDonald's Corporation, 2016 onward (United States) — negative equity, healthy business McDonald's has reported negative total shareholders' equity for several years . It bought back large quantities of its own shares, funded partly with debt, and paying more for those shares than their book value reduced equity below zero. Its ROE is therefore a negative number, or is shown as not applicable. The company remained profitable throughout. This is the case that proves the ratio is a tool and not a verdict: here a broken ROE indicates a financing policy, not distress, and an investor who screened it out on ROE would have been screening on the wrong thing.
The question that resolves it
A novice sees an ROE of 30% and asks: is this a good company?
An expert sees the same 30% and asks: how many rupees of assets is this company running for each rupee of its own money?
That single question separates a business that earns its return from one that borrows it.
What would make this wrong
If high ROE reliably identified good investments, buying the highest-ROE companies would beat the market consistently. It does not, for 2 reasons.
First, high ROE is often already in the price. A company visibly earning 35% on equity trades at a multiple that assumes it will continue. If it continues, you earn a normal return. If it does not, you lose.
Second, ROE is not stable. Studies of return on capital find strong mean reversion: companies at the top of the distribution drift down over 5 to 10 years as competitors arrive. A high ROE today is weak evidence of a high ROE in 2035.
The honest limit: everything here assumes the accounting is truthful. Equity can be inflated by capitalising costs that should have been expensed. Debt can be moved into subsidiaries or structured so it does not appear as borrowing. Interest coverage can be flattered by capitalising interest into an asset under construction. These ratios detect a bad structure. They do not detect a determined liar.
In India
Two features of the Indian market change how these ratios read.
Promoter control changes what ROE means. Most listed Indian companies have a promoter group holding a large stake. Where a family controls the company, some of the return can leave through channels other than dividends: royalty payments to a privately held parent, related-party purchases and sales, rent for promoter-owned property, and management fees. Those reduce reported profit and therefore ROE — or, on favourable terms, flatter it. The related-party transactions note in the annual report is where you check this, and almost nobody reads it. A high ROE in a promoter-controlled company is worth more when that note is small and boring.
Group structures hide leverage. An Indian group may hold operating businesses in subsidiaries and borrowings in a holding company, or the reverse. Standalone accounts can show low debt while the consolidated group is heavily borrowed. Always compute D/E from the consolidated balance sheet.
For lenders the Reserve Bank of India sets the framework, and a bank's equivalent of a solvency check is its capital adequacy ratio. Also check pledged promoter shares, disclosed to the exchanges: a promoter who has borrowed against the company's own shares has created a feedback loop between the share price and the group's solvency.
In the United States
Buybacks shrink equity and raise ROE. A US company buying back shares above book value reduces shareholders' equity. Profit stays the same, equity falls, and ROE rises with no operating improvement whatever. Over a decade of steady buybacks this moves ROE substantially. When comparing 2 US companies on ROE, look first at whether the share count has been falling.
Off-balance-sheet obligations are disclosed but easy to miss. Most leases now appear on the balance sheet as a right-of-use asset and a lease liability, which was not always true, so older comparisons are distorted. Pension obligations, which can be very large at older industrial companies, sit in the notes rather than in borrowings, and a large underfunded pension is a debt even though it is not called one.
The US advantage is disclosure depth. The 10-K contains a management discussion of liquidity, a schedule of debt maturities, and the covenants attached to major borrowings. A covenant breach is often the event that turns a solvency problem into a crisis, and in the United States you can read the covenants in advance.
Where they differ, and what that tells you
In the United States, ROE is most often distorted upward by financing choices made deliberately. Buybacks, and debt raised to fund them, shrink the denominator. The business may be excellent and the ratio still overstates it. In the extreme the ratio breaks entirely and reports a negative number for a thoroughly healthy company.
In India, ROE is most often distorted by where the profit goes and by what the group structure hides. Related-party flows move profit between listed and unlisted entities. Consolidated debt sits in a different company from the one you are reading about.
What that tells you is a different first check in each market. For a US company, look at the change in share count and at total equity over 5 years before you trust an ROE. For an Indian company, read the related-party transactions note and compute leverage from the consolidated accounts before you trust one.
The shared lesson is the same in both places. ROE is 3 numbers pretending to be 1, and the DuPont split takes 3 minutes.
Carry this
- ROE = margin × turnover × leverage. Split it before you use it.
- ROCE tells you if the business is good. ROE tells you what borrowing did.
- Interest coverage is the number that predicts trouble. D/E on its own does not.