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Return on Equity: Financial Statement Interpretation
Volkswagen
The German automobile company was created in 1937 under the Volkswagen group of companies and is recognized as one of the top-selling automakers in the entire world. In fact, it is considered to be the second largest automobile manufacturing company in the automotive industry. As such, three of its products are in the top ten of bestselling cars. Better still, the company recorded $244.985 billion in revenues as of 2014. With a workforce of 588,902 employees and $424.982 billion in total assets, the company generated $13.393 billion profits (Morrow, 2016).
The company has focused its primary goal to double its market share in the United States. Through this, the firm would be focusing on its vision of becoming the world’s largest manufacturer of automobiles by the year 2018. In keeping faithful to this vision, they are expanding to bigger markets with the major ones being Germany and China (Morrow, 2016).
Return on Equity
Return on equity checks the return on the shareholders’ equity. In simpler terms, it measures the firm’s efficiency in earning profits from every unit of the shareholder’s equity. This means that a company needs to invest funds in an appropriate manner for them to get growth in their earnings. It is essential to note that measuring consistent margins in earnings per share does not sufficiently explain the performance. Therefore, Return on equity serves to be the best profitability ratio in measuring efficiency in performance. In this case, Volkswagen’s Return on equity ROE using the Du Point analysis for the last two years would be;
ROE using the DuPont method = (net income/revenue) * (income/assets) * (assets/equity)
Or
ROE = (RNOA) + Return on debt
2015 = -1.67
2016; (10271.714922/227011) * (227011/429031.72385) * (429031.72385/97714.633) = 10.51
High return on equity mean that firms are not capital intensive. However, even if there are high returns with leverage in 2016, there is still a solid balance sheet. This means that the firm has utilized little of its capital this year on income-generating investing as opposed to 2015. All in all, it is critical to invest in firms with high Return on equity as they fluctuate due to company earnings or cycles when looking at long-term investments. For that reason, investors should look at investing in this year’s company ventures for them to get high returns.
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Microsoft
Microsoft is an American technology company that deals with the manufacture and distribution of computer software, electronics, as well as services. It is also recognized as the world’s largest software company and the most valuable. Founded in 1975, the company had its headquarters in Washington and recorded a revenue of $93.58 billion by 2015. It is also noted that the company has produced billionaires and millionaires from its 118,584 employees. More so, the firm is known to register high profits with a net income of $12.19 in 2015. As such, the company continues to grow to be a major player in the computer and electronics industry.
Return on Equity
ROE using the DuPont method = (net income/revenue) * (revenues/assets) * (assets/equity)
(Net profit margin) * (Asset turnover) * (Leverage)
2014; (25.42%) * (0.50) * (1.92) = 24.59%
2015; (13.03%) * (0.53%) * (2.20) = 15.23%
As stated earlier, firms that have registered high ROE often generate more cash rather than investing it. Even though, higher Return on equity show that the company is making good use of their equity in making more income, they are not exhausting their full potential in investments. In this case, Microsoft’s 2015’s Return on equity is lower than in 2014 by 9.36%. This means that they have been investing more rather than making profits. As a result, their balance sheet is not rigid since cash is always flowing in and out of investments. Better still, the higher rates of ROE show that the company is making good use of efficiency in utilizing their capital or shareholders’ equity in generating more income.
Walmart
In the same sense as Microsoft, Walmart is an American company but classified under the retail industry where it manages hypermarkets, departmental stores, and groceries. The firm has grown to establish 11,543 stores in 28 countries with its main operations being in the United States and Canada. The company has a registered revenue of $482.13 billion by 2016 thereby being recognized as the world’s largest firm by revenue. The family-owned business is also the most valuable enterprise through its attractive market value.
Being the biggest grocery retailer in the United States, its net income adds up to $14.694 billion even though it has employed 2.2 million people in all its global branches. However, it struggles to get a bigger market share by venturing into the growing and emerging Chinese and another Asian market. Also, they set low prices for their products in order to get a large customer base. Additionally, since the business is the biggest private employer in the United States, its turnover rate significantly affects the unemployment rates. In the same regard, they have faced numerous charges ranging from lawsuits to labor strikes.
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Return on Equity
ROE using the DuPont method = (net income/revenue) * (income/assets) * (assets/equity)
(Net profit margin) * (Asset turnover) * (Leverage)
2016; (3.07%) * (2.40%) * (2.48%) = 18.24%
2015; (3.39%) * (2.37%) * (2.50%) = 20.10%
Businesses that have higher returns on equity are focused on protecting their net income in facing the competition. This is so since they generate more income with little need of reinvesting it yet they have the ability to increase their business value. Still, higher Return on equity means having good business value since the stock prices will appreciate in a bid to trade with the firm’s growing value.
But, is having more shares worthwhile than investing the gained income? In the above recordings, it is clear that Walmart is making god use of their shareholders’ equity in generating more income for the business. However, the generated income is to place the company at the top of their rivals and in the stock market. Fortunately, the Return on equity decreased from 20.10% in 2015 to 18.24% in 2016 due to further reinvestment of their gained earnings.
From the above statistics, it is clear that both Microsoft and Walmart understand the importance of reinvesting their income in profitable ventures rather than having a solid balance sheet. On the other hand, Volkswagen is increasing their Return on equity perhaps to recapture their market position. The firm might also have decided not to reinvest their earnings probably to increase their value and better trading stocks in the stock market.
Company Analysis
Current Ratio
The current ratio measures a organization’s ability to offset its short-term debts or meeting its obligations. It gives the efficiency of a company’s operations to turn the product into cash. This is understood through the fact that businesses that are unable to pay their short-term debts often have liquidity problems.
It is given as; Total current liabilities/total current liabilities
For the first quarter in 2016;
Volkswagen – 179895.323/177672.61 = 1.01
Walmart – 59097/70282 = 0.84
Microsoft – 128421/44354 = 2.90
(Financials are given in millions)
The higher the ratio is, the more likely a company is able to pay its short-term debt. Therefore, a current ratio that is under 1 means that the establishment is having difficulties in paying off its obligations. Even though this is an indication the firm is not in good financial vigor, it does not inevitably mean that they will go broke (Christensen, Baker & Cottrell, 2014).
This means that Walmart’s first quarter performance is not good since they are having difficulties paying off their short-term debt. However, if the company has satisfying long-term projections, it may be able to borrow and pay off its obligations. In the same sense, Microsoft proves to be most efficient in paying off its short-term liabilities compared to the rest.
Quick Ratio
Though almost similar to current ratios, quick ratios show the practice’s ability to meet its short-term debt through its most liquid assets such as cash. As a result, inventories are excluded since they are less liquid.
For that reason, it is given through;
(Total current assets – portfolio)/ total current liabilities
For the first quarter in 2016;
Volkswagen – (179895.322 – 39936.526)/ 177672.606 = 0.79
Walmart – (59097 – 44513)/ 70282 = 0.21
Microsoft – (128421 – 2450)/ 44354 = 2.84
(Financials are given in millions)
Generally, a low quick ratio is an indication that a company is over-leveraged or is finding it hard to increase its sales, pay bills or is collecting their income slowly. From the other perspective, a higher quick ratio shows that a business is able to meet its financial obligations (Christensen, Baker & Cottrell, 2014). As such, they often have a faster inventory with fast conversion cash cycles. In this regard, Both Volkswagen and Walmart and struggling to meet their financial obligations. They cannot fully pay their current debt. Conversely, Microsoft shows good financial strength in its short term.
Net Profit Margin
Net margin is often used in assessing a company’s profitability and value estimation but is not entirely reliable. This is so because they can be easily manipulated by changing the methods of depreciation or altering the standard accounting practices. They are given through;
Net profit margin – net income/revenue
For the first quarter in 2016;
Volkswagen – 2630.290/56752.784 = 4.63
Walmart – 3079/115904 = 2.66
Microsoft – 3756/20531 = 18.29
(Financials are given in millions)
In this case, Microsoft company is the most profitable firm in the sense has it has the highest net profit margin with Walmart having the least profit margin. Microsoft is, therefore, ranked as having a net margin higher than 79% of the companies in the global software and infrastructure industry. In the same regard, Walmart was 68% higher in the retail industry while Volkswagen was 83% higher in net margins in the automotive industry.
Asset Utilization
Asset utilization involves the calculation of returns on Assets which measures the efficiency in which a firm uses their assets to generate income (Christensen, Baker & Cottrell, 2014). In short, it shows how well a company uses what it has to generate income. Therefore, it is given by;
Asset utilization – (net income/revenue) * (revenue/average total assets)
For the first quarter in 2016;
Volkswagen – (10521.1581/227011.136) * (227011.136/429031.724)= 2.45
Walmart – (12316/463616) * (463616/199143) = 6.18
Microsoft – (15024/82124) * (82124/180983) = 8.30
Similar to the return on equity, asset utilization can be affected by dynamic business cycles. Due to this, the ratio becomes crucial when looked at in the long-term perspective. Due the many factors such as stock buyback, may make the ROA not reflect the specific earning authority of the assets. ROA and ROE should not be used in the comparison of firms that are in different industries (Christensen, Baker & Cottrell, 2014). Microsoft’s ROA is higher than the rest of the companies even though they are in different industries.
Financial leverage
Financial leverage is recognized as the ability of an enterprise to use its debt in acquiring assets. It is also commonly known as trading on equity. It is given through;
Financial leverage – average of the total assets/average of the total equity
For the first quarter in 2016;
Volkswagen – 429031.724 / 97714.633 = 4.391
Walmart – 199143/77864.5 = 2.558
Microsoft – 180983.5/75793 = 2.388
When the value of assets falls, the financial leverage may fail to be beneficial. They do not guarantee the success of any business (Christensen, Baker & Cottrell, 2014). Volkswagen is, therefore, risking due to its high financial leverage in the event of having a decline in sales. From the above recordings, Microsoft is taking less risky investments of using debt to acquire assets as opposed to Walmart and Volkswagen.
Conclusion
Comparing companies in different industries is not always easy due to the variety of factors that involve the various operations that are undertaken. As stated above, ROE and ROA will not be useful when comparing the companies since they are from various industries (Christensen, Baker & Cottrell, 2014). In the same regard, manufacturing companies will have different accounting methods.
The allocation of resources and elements will be different. The service industry often has little overhead costs that lead to higher revenues that are converted to profit. On the other hand, manufacturing companies have higher revenues due to the variety of products and the costs. It is also to note that the difference in accounting is due to the standards applied. Inventory costs in IFRS are not allowed as opposed to GAAP standards.
Similarly, write-downs are reversed under the IFRS while it is not allowed in under GAAP. The IFRS are based on principles while the U.S. GAAP focus on rules. Therefore, IFRS better present economic transactions. However, all companies have shown efficiency in using their working capital even though they are done in different degrees (Christensen, Baker & Cottrell, 2014). All in all, Microsoft proves to be most efficient and having more financial strength.
References
Christensen, T. E., Baker, R. E., & Cottrell, D. M. (2014). Advanced Financial Accounting. The McGraw-Hill Companies, Inc.
http://www.gurufocus.com/term/ROE/MSFT/Return-on-Equity/Microsoft-Corp
http://www.gurufocus.com/term/ROE/VLKAY/Return-on-Equity/Volkswagen-AG
http://www.gurufocus.com/term/ROE/WMT/Return-on-Equity/Wal-Mart-Stores-Inc
Hurd, J., Lawman, M., Salkowski, Z., Sampson, H., & Stellato, A. (2014). Wal-Mart Case Study.
Morrow, R. (2016). Corporate Social Responsibility and Corporate Financial Performance: An Empirical Analysis. Available at SSRN.
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