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QuestionsCategory: Financials QuadrantModule 5: Return on Equity
Tony asked 3 years ago

Hi,
I have a question in relation to module 5 on ROE. Below is an excerpt of the explanatory notes below the video:

A company pays for the stuff it owns (assets) either by borrowing money (liabilities) or by getting it from shareholders (shareholders’ equity). When a company chooses to borrow a lot of money over using shareholders’ money, liabilities increase while shareholders’ equity decreases in tandem.
When shareholders’ equity is reduced, ROE is increased as now the same amount of net profit is generated using less shareholders’ equity. Even though the company can achieve a high ROE this way, it is is now exposed to more risk; banks can increase interest rates or call back the loan at any time.

The underlined part puzzles me. My understanding is that, no matter how much money a company borrows from banks or other sources, the shareholders’ equity should remain unchanged. Through a bit of research on google, I have formed the understanding that, if a company’s asset consist of a first portion of liability and a second portion of shareholder equity, the return is attributed to the asset, more particularly to both the first portion and the second portion. Therefore, if a potential investor does not consider the first portion (the liability), he or she would be gullible to believe that the whole of the return is earned by the company using only the second portion, which makes the ROE seems larger than it really is.
It would seem to me that, if the first portion of liability accounts for 90% of the asset and the second portion of shareholder equity accounts for only 10%, then 90% and 10% of the return are attributed to the liability (borrowed money) and the shareholders equity, respectively. Is my understanding correct?
Can someone confirm my understanding please? Thank you!
Tony

2 Answers
Jieren Zheng answered 3 years ago

ROE is Net Profit over Equity

Asset – Liability = Equity (I think just remember as that).

Equity is just like your home equity (paid up portion of your flat).

Say if you rent your home out, assuming the rent for the year is same, the more you borrow, the lower the equity you have. So if you shrink the denominator (equity), it seems that the return is much higher.

i.e rental is 3k per month (a conservative estimate would be 10 months rental per year, not gonna include maintenance, tax, etc for simplicity) = 30k
your flat is 500k (I’m not gonna include fees etc for simplicity)
a) you pay 30% downpayment, 70% loan (30k / 150k = 20%)
b) you pay 10% downpayment, 90% loan (30k / 50k = 60%)

Can you see the difference?

Hope it helps.

Tony replied 3 years ago

Thanks Jieren. I see the difference. I think the the explanatory note should be clarified to say “relatively increases” rather than just “increases”.

Victor Chng replied 3 years ago

Thanks JR

Jieren Zheng replied 3 years ago

Welcome :)

Victor Chng answered 3 years ago

Hi Tony,

As what Jieren had explained this is how you should look at ROE.

Tony replied 3 years ago

Okay. Thanks!