ROE, ROA, debt ratio — numerator–denominator play again

Numerator–denominator play, the corporate finance edition

Lesson 1-3 said finance is numerator–denominator play. The balance sheet and income statement give us the raw materials. Now we combine them into ratios — small fractions that tell us specific things about a company's quality.

The most-used ratios fall into three groups: profitability, leverage, and liquidity. Each one is a fraction with a specific meaning.

Profitability ratios — how efficiently is the company turning resources into profit?

Return on Equity (ROE) = Net income / Shareholders' equity

How much profit per dollar of shareholder capital. Higher = more efficient use of equity. The Holy Grail of profitability metrics. Long-term healthy ROEs in the developed world are 12-20%; world-class compounders sometimes sustain 25-35%.

Return on Assets (ROA) = Net income / Total assets

How much profit per dollar of assets. ROA < ROE because assets include debt-financed parts. ROA tells you about asset productivity regardless of capital structure.

Net margin = Net income / Revenue (from lesson 5-2). How much of each revenue dollar becomes profit.

Leverage ratios — how much debt is the company using?

Debt-to-Equity = Total debt / Equity. From last lesson. High = more leveraged. Banks and utilities run high; tech companies often run low.

Interest coverage = EBIT / Interest expense. How many times can the company's operating earnings cover its interest payments? >5 is comfortable; <2 is danger zone.

Liquidity ratios — can the company pay near-term bills?

Current ratio = Current assets / Current liabilities. From last lesson. <1 = potential trouble.

Quick ratio = (Current assets − Inventory) / Current liabilities. Stricter (excludes inventory, which can be slow to convert to cash).

The DuPont decomposition — ROE seen as three levers

One famous decomposition shows that ROE breaks into three pieces:

Reading: Net margin × Asset turnover × Leverage ratio. Three independent ways a company can boost ROE — be more profitable per sale (margin), turn assets over faster (efficiency), or use more leverage. They have very different sustainability profiles.

A high-ROE company driven by leverage is fragile. A high-ROE company driven by margins and turnover is strong. Same headline number, very different stories. This is why ratios alone aren't enough — you have to read what's behind them.

The takeaway

Ratios = small fractions that summarize one aspect of the company. Profitability (ROE/ROA/margin), leverage (D/E, interest coverage), liquidity (current/quick ratio). All numerator–denominator play. The DuPont decomposition shows ROE has three drivers — margin, turnover, leverage — and the same ROE built differently means very different things. Ratios are pointers; the underlying drivers are the story.