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:

CSL Limited 2016 2015 2014 2013 2012
Net Income (US$) 1,242 1,379 1,307 1,211 1,024
Total equity (US$) 2,567 2,746 3,162 3,018 3,477
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.

Foolish takeaway

To me, CSL is to healthcare what Johnson & Johnson is to consumer products, or what Nestlé is to snack foods; a well-structured staple producer with low cyclical volatility and strong margins and volumes.

It’s a company I would love to own, and I will certainly be watching for any further weakness in share price.

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Motley Fool contributor Regan Pearson has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.