Don’t be fooled by last week’s dip in share price as CSL Limited...

Don’t be fooled by last week’s dip in share price as CSL Limited (ASX: CSL) reported its annual results. The company is in great shape.
Cash flow from operating activities was up a solid 6%, the company continued to invest in R&D and over US$1.2 billion in cash was returned to investors through dividends and share buy-backs.
Returns on equity holding strong
But one of the features I like most about CSL is its huge return on equity (ROE), which completely blows away the 10% average for U.S. healthcare product companies. Let’s take a look and see how it held up in the 2016 financial year:

	Column 1	Column 2	Column 3	Column 4	Column 5	Column 6
0	CSL Limited	2016	2015	2014	2013	2012
1	Net Income (US$)[/B]	1,242	1,379	1,307	1,211	1,024
2	Total equity (US$)	2,567	2,746	3,162	3,018	3,477
3	ROE	48%	50%	41%	40%	29%

It’s interesting to see that although ROE held strong over the last 12 months, both net income and total equity dropped.
Net income dropped mostly because the company was investing more cash into its new Seqirus Influenza business. Meanwhile equity dropped as the company took on more debt to fund the acquisition. Both points show that CSL is continuing to reinvest for long-term growth which is good news.
Why does CSL use debt, rather than fund the growth from its strong cash flows? With borrowing costs so low it makes sense to use debt to fund moderate growth if the company knows it can generate new income to pay it back.
Breaking down return on equity
To see where CSL’s huge 48% ROE comes from, we can break it out into three components using the DuPont analysis:

1. Net profit margin (Net Income ÷ Revenue) 0.21
2. Asset Turnover (Revenue ÷ Assets) 0.78
3. Equity Multiplier (Assets ÷ Shareholders’ Equity) 2.95

Return on equity = (0.21) x (0.78) x (2.95) = 48.32%
Even by healthcare standards CSL’s 48% ROE is insane, with only Cochlear Limited (ASX: COH) coming close. But when we break it down we can see that the big driver of the returns is CSL’s use of debt to fund assets; the high equity multiplier. Without this, if CSL didn’t leverage its assets with borrowed money, ROE would only be 16.38%.
That’s not to say the company is over leveraged, especially when CSL has strong cash flows to service the interest, but if a comparable investment had a higher unleveraged return, we may prefer to buy it.