Thread by @themoneymemo

How Return on Equity (RoE) can be manipulated:

A short 🧵:

💰💰🔥🔥

#invest #Financial

First, let’s take the formula to calculate Return on Equity (RoE):

RoE = (Net Profit/Shareholders’ Equity) x 100

Here, we need to understand what shareholders’ equity stand for in the Balance Sheet:

#stocks #investing

If the company has assets worth ₹1000/- then liabilities also need to be ₹1000/-.

With no debt, in a simple world, the liability would be the shareholders’ equity. Let’s say Net profit is ₹100/-

And RoE would be :

(100/1000) x 100 = 10%

But everything changes with debt.

Let’s say the company takes on ₹200/- of debt. If the assets remain the same, the balance sheet would now look like this:

Assets : ₹1000/-
Debt : ₹200/-
Shareholders’ equity : ₹800/-

Now what would be the RoE?

RoE would be as follows in this case:

RoE = (100/800) x 100 = 12.5%

Did you see how RoE increased by 2.5% when the company took on debt? 💡💡🧠🧠🧐🧐

A company with high debt (like Adani) can show a higher RoE in this way!

What’s the takeaway from this example?

#invest

Always use profitability ratios - like RoE - in conjunction with other ratios, especially Debt-to-Equity and Interest Coverage ratios.

A heavy debt-laden company with a high RoE may not be a good investment!

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