Let me show you a picture to tie this together.
So we start with return on equity, and that can be split up in two components.
Operating performance, which is return on assets and
the financial leverage component.
And so you see in the equation,
we have ROE equals net income over assets times assets over equity.
The assets cancelled, we get ROE equals net income over equity.
Let me do a quick example.
So company raises $100 from shareholders, borrows $100 from a bank to buy
$200 of assets, those assets are then used to generate $10 of net income.
So ROE in this case would be 10%,
$10 of net income divided by $100 from shareholders.
ROA would be 5%, $10 of net income divided by 200 of assets.
And the leverage would be 2,
$200 of assets divided by a $100 of share holders equity.
Multiplying it together 5% ROA times a leverage of 2 gives you an ROE of 10%.
In this highlight how these two components drive ROE.
So let's say instead of buying $200 of assets with $100 of shareholders equity,
we bought $400 of assets.
We borrowed 300 from the bank,
combine that with our 100 from shareholders to buy 400 of assets.
Now our leverage is 4.
If we can maintain the same ROA of 5%, our ROE would go up to 20%.
Or let’s say we keep leverage at 2 but we find a way to
operate the business more efficiently to get the performance or the ROA up to 10%.
Then we would have 10% ROA times a leverage of 2 would give us ROE of 20%.
So either operating performance or leverage can get you to a high ROE.
