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 (LSE: MRW) (NASDAQOTH: MRWSY.US), 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. Return on equity can be calculated by dividing a company's annual earnings by its equity (ie, the difference between its total assets and its total liabilities) and is expressed as a percentage.
Morrisons 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:
Morrisons' ROE has been extremely consistent over the last four years, and its five-year average of 12.0% is similar to those of other UK 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 Morrisons' net gearing and ROE alongside those of its peers, Tesco and J. Sainsbury:
The supermarkets' average ROE and net gearing appear to be closely correlated, highlighting the influence that debt can have on ROE.
Morrisons has committed to spend £241m setting up its home delivery service, and the firm is also investing in new smaller, local stores. As a result, total debt is expected to rise from £2.4bn to £2.7bn this year.
Morrisons' online food business isn't expected to make a positive contribution to earnings until 2016/17, so the next couple of years could see Morrisons' profits come under pressure.
Is Morrisons a buy?
Morrisons currently trades on a forecast price-to-earnings ratio (P/E) of 10.5, and a prospective yield of 4.7%.
It's also worth remembering that Morrisons' 2012 operating margin of 5.2% was higher than those of both Tesco (3.4%) and Sainsbury (3.8%).
I think that Morrisons looks like a good income buy at the moment, with long-term growth potential.
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