Question

Is it possible for the amount of debt of a company to affect the level of return on equity (ROE)?

Answer 1

Return on equity is calculated by dividing annual earnings by average shareholder equity over the year. Annual earnings are listed in a company's annual report. Shareholder equity is listed in the balance sheet. In establishing a true picture of shareholder equity, check the company's quarterly statements to see if shareholder equity has fluctuated during the year.

Debt and ROE

Increased debt increases the leverage factor in a company. During normal or boom times, leverage results in exponential profit returns. During recessions, leverage can result in exponential losses, as well. A large debt burden carries risk because of the reaction of leverage to the prevailing economic conditions. Increased debt favors ROE during boom times but hurts ROE during recessions.

Trading on Equity:

Trading on equity occurs when a corporation uses bonds, other debt, and preferred stock to increase its earnings on common stock. For example, a corporation might use long term debt to purchase assets that are expected to earn more than the interest on the debt. The earnings in excess of the interest expense on the new debt will increase the earnings of the corporation's common stockholders. The increase in earnings indicates that the corporation was successful in trading on equity.

If the newly purchased assets earn less than the interest expense on the new debt, the earnings of the common stockholders will decrease.