Welcome to my new blog post. In this I would be explaining the effects of Leveraging on the Return on Equity (ROE). ROE is one of the important ratio to be analysed before investing in a company. So let me take you through what is ROE and Debt to Equity Ratio.
Return on Equity
When a company needs some capital, they have 3 options for raising funds that are taking debt, issuing bonds, or raising equity. Basically, ROE shows how a company is using its equity/shareholders fund to generate profits. Higher the better. But it also depends on companies to companies as not every company has the same business model.
ROE can simply be calculated by: Net income/ Shareholder’s equity.
Debt to Equity Ratio
This ratio tells us how much debt the company has as compared to equity funds. High D/E indicates higher risk.
Debt to Equity ratio is calculated by the Total amount of debt/Shareholder’ equity.
Now that you have understood both the ratios, let’s now talk about how leveraging impacts the risk.
Let me explain this by an example.
Assume that there are 2 companies in the same industry.
Let’s say company ‘A’ raises Rs.100 purely through equity (100% Equity) and the company ‘B’ raises Rs. 50 through debt and Rs. 50 through equity so D/E ratio becomes 1.
Company A: Raises Rs.100 by issuing 10 shares at Rs.10.
Company B: Raises Rs.50 through debt at 8% interest and Rs.50 through equity by issuing 5 shares at Rs.10.
Notations: VC- Variable Cost, FC- Fixed cost, EBIT- Earnings before interest and tax, PAT- Profit after tax.
Interest= 50 X 8% =4
ROE= For 2019, 36/50 = 72%; For 2020, 54/50= 108%
Note that this was just a hypothetical example. From the table above, you can see that ROE of Company A is lower than B, though their sales and expenses (except interest) were the same. By leveraging, ROE can grow significantly only if earnings increases.
If earnings decreases, the ROE decreases significantly if leveraged. So having high debt is risky but also rewarding if handled properly. Many investors doesn’t like leverage companies as it increases the risk.
So ultimately, debt amplifies the profits and also on the other hand can amplify the losses. Many companies had gone bankrupt due to high leverage and not able to generate returns from the business. Therefore, having debt is not a problem unless and until it is at an optimal level.
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