High ROE with a high debt ratio: why the same number has two faces

Looking through stocks, you run into combinations that seem not to add up: a company with ROE at the top of its sector and a debt ratio ranked near the bottom. Its profitability score is high and its financial stability score is low, so it is hard to tell whether it is a good company or not.

A common reaction is to suspect one of the numbers is wrong. But both are accurate. They simply answer different questions. ROE asks “how much did the company earn on the money shareholders put in”, and the debt ratio asks “how much debt did it use along the way”.

And these two questions are not independent. Using debt raises ROE. So the two metrics are not pointing in opposite directions; they are looking at one fact from the front and from the back.

ROE is net income divided by equity. There is a long-established method that breaks this single figure into a product of three factors: net margin, asset turnover and financial leverage.

Net margin shows how much of every KRW 100 in sales is left as profit. Asset turnover shows how many times the company turned its assets into sales. Financial leverage shows total assets as a multiple of equity, in other words how much borrowed money was added to grow the business. Multiply the three and the result is ROE.

What this breakdown shows is that the same 15% ROE can come by entirely different routes. A 15% from thick margins, a 15% from turning assets over quickly, and a 15% from piling on debt differ both in the nature of the company and in the size of the risk.

That route is exactly what gets lost when companies are compared on a single number. Looking at ROE alone, the three are indistinguishable.

Of the three parts, financial leverage connects directly to the debt ratio. If equity stays the same and assets grow with borrowed money, total assets get larger, and so does financial leverage, total assets divided by equity. Even if the first two parts are unchanged, the last term of the product has grown, so ROE goes up.

That is not necessarily a bad thing. If the profit made with borrowed money exceeds the interest on it, leverage pays off for shareholders. A company in its growth phase borrowing to expand capacity and grow profit is making a normal management decision.

The problem comes when the direction reverses. Leverage magnifies losses by the same factor as profits. If sales falter or interest rates climb, the very structure that pushed ROE up now pushes the loss deeper. A high ROE together with a high debt ratio means a structure in which the company's results can swing widely up and down.

So when looking at a company with a high ROE, it pays to check where that height came from. The debt ratio and interest coverage are the numbers for that check. Interest coverage shows how many times operating income covers interest expense, so it is used to gauge whether leverage is still within a safe range.

Jupick's grade is calculated from nine metrics divided into three areas: profitability 40%, financial stability 35% and dividends 25%. ROE belongs to profitability; the debt ratio and interest coverage belong to stability.

The reason for the split ties directly to the subject of this article. Simply averaging the nine metrics would let an ROE pushed up by leverage cancel out the stability score that the same leverage drags down. The result would be one middling score, and what kind of company it is would disappear.

Scoring separately prevents that cancellation. The combination of top profitability and low stability stays visible on screen, and a reader can see the company's character as one that uses capital aggressively. The overall grade is only a summary layered on top.

In the area-by-area scoring on the stock page, you can see how many points out of 100 each metric received. Even within the same grade, where points were gained and where they were lost differs.

Follow the leverage story to the end and an extreme case appears. When a company repurchases its own shares on a large scale for years, accounting equity shrinks and, cumulatively, can turn negative. Some large companies that earn steady profits are in this position.

When equity is negative, ROE can still be calculated but loses its meaning. The value comes out negative even though the company is profitable, and as equity approaches zero the value shoots toward infinity. That is why many data sources do not provide an ROE value at all in this case.

Jupick does not fill these blanks with zero; it treats them with a neutral fill-in value and shows a hyphen with the reason on screen. Filling with zero would have given a profitable company the lowest profitability score. This handling is covered in more detail in a separate article.

What this case shows is that companies really do move outside the range in which a metric holds. When reading a number, it is worth checking whether it is within its valid range too.

ROE uses accounting equity as its denominator. But equity depends on when the company acquired what and at what price, how many of its own shares it repurchased, and how it handled the accounting. When the denominator moves for reasons unrelated to business performance, ROE moves with it.

Comparisons across sectors have limits too. Sectors that need few assets structurally produce high ROE, and sectors that need large plants produce low ROE. Ranking ROE across different sectors mostly ends up ranking the nature of the sectors.

And ROE summarizes past results. It records that such a result happened in a period already gone, not a promise that it continues. This matters more the more leverage is built into the ROE, because it is the number that shakes first and hardest when conditions change.

This content is for information only and is not investment advice. Investment decisions and responsibility for them rest with the user.