Did Square, Inc. (NYSE:SQ) Use Debt To Deliver Its ROE Of 16%?

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. To keep the lesson grounded in practicality, we'll use ROE to better understand Square, Inc. (NYSE:SQ).” data-reactid=”28″>While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. To keep the lesson grounded in practicality, we’ll use ROE to better understand Square, Inc. (NYSE:SQ).

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content=" View our latest analysis for Square ” data-reactid=”30″>View our latest analysis for Square

How Is ROE Calculated?

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="ROE can be calculated by using the formula:” data-reactid=”36″>ROE can be calculated by using the formula:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders’ Equity

So, based on the above formula, the ROE for Square is:

16% = US$303m ÷ US$1.9b (Based on the trailing twelve months to June 2020).

The ‘return’ refers to a company’s earnings over the last year. That means that for every $1 worth of shareholders’ equity, the company generated $0.16 in profit.

Does Square Have A Good ROE?

One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. If you look at the image below, you can see Square has a similar ROE to the average in the IT industry classification (15%).

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="That isn't amazing, but it is respectable. Although the ROE is similar to the industry, we should still perform further checks to see if the company's ROE is being boosted by high debt levels. If a company takes on too much debt, it is at higher risk of defaulting on interest payments. To know the 4 risks we have identified for Square visit our risks dashboard for free.” data-reactid=”55″>That isn’t amazing, but it is respectable. Although the ROE is similar to the industry, we should still perform further checks to see if the company’s ROE is being boosted by high debt levels. If a company takes on too much debt, it is at higher risk of defaulting on interest payments. To know the 4 risks we have identified for Square visit our risks dashboard for free.

The Importance Of Debt To Return On Equity

Virtually all companies need money to invest in the business, to grow profits. That cash can come from retained earnings, issuing new shares (equity), or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the debt used for growth will improve returns, but won’t affect the total equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.

Square’s Debt And Its 16% ROE

It’s worth noting the high use of debt by Square, leading to its debt to equity ratio of 1.16. There’s no doubt its ROE is decent, but the very high debt the company carries is not too exciting to see. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.

Summary

Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. A company that can achieve a high return on equity without debt could be considered a high quality business. If two companies have around the same level of debt to equity, and one has a higher ROE, I’d generally prefer the one with higher ROE.

<p class="canvas-atom canvas-text Mb(1.0em) Mb(0)–sm Mt(0.8em)–sm" type="text" content="Having said that, while ROE is a useful indicator of business quality, you'll have to look at a whole range of factors to determine the right price to buy a stock. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So you might want to check this FREE visualization of analyst forecasts for the company.” data-reactid=”62″>Having said that, while ROE is a useful indicator of business quality, you’ll have to look at a whole range of factors to determine the right price to buy a stock. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So you might want to check this FREE visualization of analyst forecasts for the company.