LONDON — Before I decide whether to buy a company’s shares, I always like to look at two core financial ratios — return on equity and net gearing.
These two ratios provide an indication of how successful a company is at generating profits using shareholders’ funds and debt, and they have a strong influence on dividend payments and share price growth.
Today, I’m going to take a look at Wm. Morrison Supermarkets plc (LON:MRW) to see how attractive it looks on these two measures.
Return on equity
The return a company generates on its shareholders’ funds is known as return on equity, or ROE. ROE can be calculated by dividing a company’s annual earnings by its equity (i.e., the difference between its total assets and its total liabilities) and is expressed as a percentage.
Wm. Morrison Supermarkets plc (LON:MRW) has doubled its annual dividend payout over the last five years, rewarding long-term shareholders. Let’s take a look at the firm’s ROE over the same period:
| Wm. Morrison | 2009 | 2010 | 2011 | 2012 | 2013 | Average |
|---|---|---|---|---|---|---|
| ROE | 10.3% | 12.6% | 12.2% | 12.8% | 12.2% | 12% |
Morrisons’ ROE has been extremely consistent over the last four years, and its five-year average of 12% is similar to those of other U.K. supermarkets.
What about debt?
One weakness of ROE is that it doesn’t show how much debt a company is using to boost its returns. A good way of assessing a company’s debt levels is by looking at its net gearing — the ratio of net debt to equity.
In the table below, I’ve listed Wm. Morrison Supermarkets plc (LON:MRW)’ net gearing and ROE alongside those of its peers,Tesco and J. Sainsbury:
| Company | Net Gearing | 5-Year Average ROE |
|---|---|---|
| J. Sainsbury | 39.5% | 10.5% |
| Wm. Morrison | 41.4% | 12% |
| Tesco | 46.9% | 15.5% |
The supermarkets’ average ROE and net gearing appear to be closely correlated, highlighting the influence that debt can have on ROE.
