Return on equity compares the annual net income of a business to its shareholders' equity. The measure is used by investors to determine the general level of return that an organization is generating in proportion to the investment they have made in it. A business that can generate a high return on equity is considered to be a good investment, which drives up its share price.
However, an analysis of the return on equity measurement reveals that this level of investor enthusiasm could be misplaced. A key concern with the return on equity is that it can be heavily influenced by replacing equity with debt. Company management could simply incur debt and use the proceeds to buy back shares, rather than using the money to increase profits. By doing so, the equity base in the denominator of the return on equity calculation declines, while the net profit figure in the numerator remains approximately the same. The following example illustrates the situation.
ABC International has net profits of $100,000 and shareholders' equity of $500,000. This means that its return on equity is 20% which is calculated as follows:
$100,000 Profit ÷ $500,000 Equity = 20% Return on equity
The president of the company analyzes the return on equity situation and decides to incur $200,000 of debt at an after-tax interest rate of 8%, using the debt to buy back shares. Doing so reduces the profit by the interest expense of $16,000. The outcome of this change is as follows:
$84,000 Profit ÷ $300,000 Equity = 28% Return on equity
In short, the president has used financial engineering to increase the return on equity from 20% to 28%, without doing anything to improve the underlying profitability of the business.
The problem with adding debt to a company's balance sheet is that the business may not have sufficiently stable cash flows to support the ongoing interest payments associated with the debt; it may also not be able to pay back the debt, and so will be forced to roll it over into new debt whenever the debt instrument reaches its maturity date.