The High ROE Illusion: When Leverage Masquerades as Excellence How impressive returns can hide a fragile business model
by Michael Lamonaca 31 January 2026
I’m reading the financial statements of a company, and one of my first screening metrics is the five-year return on equity. This one jumps out immediately: 34% ROE over the past five years, climbing to 36% over the decade. That’s exceptional—well into top-quartile territory. Most investors would see that number and think “quality business worth investigating.”
But I never stop at ROE alone. What looks like excellence on the surface reveals itself as an illusion built on leverage, thin margins, and minimal cash generation. Let me show you exactly what I found.
The headline number looks impressive. Return on equity of 34-36% signals strong returns for shareholders. The company can pay off its long-term debt within a year from net income—that 1x coverage ratio looks manageable.
But everything else tells a different story. Gross profit margins sit at just 12%—the company keeps barely $12 from every $100 in revenue after direct costs. Net income margins are even thinner at 3%—after all expenses, just $3 remains from every $100 in sales.
Total debt stands at 122% of equity (was 138% historically). The company owes more in debt than shareholders own. Total liabilities run 3.1 times equity (down from 3.6x)—for every dollar shareholders own, the company owes over three dollars.
The current ratio sits at 1.2—current assets barely exceed short-term liabilities. For a business carrying this much debt, that’s inadequate cushion.
Retained earnings grew just 0.5% over the past five years compared to 8.6% historically. This collapse means the company is generating far less profit to reinvest—a clear sign of deteriorating performance.
And the metric that reveals real fragility: free cash flow represents just 1.3% of revenue. Out of every $100 in sales, the business converts barely $1.30 into actual cash it can use.
This combination paints a clear picture: high ROE achieved through extreme leverage, not operational excellence.
Let me translate these numbers into something concrete. Meet Rocco, a shoemaker who crafts leather shoes in his workshop and sells them through three retail locations.
Rocco started with $10,000 of his own money—his workbenches, tools, and initial inventory. That’s his equity, what he actually owns.
To open his three shops, Rocco borrowed $12,200 from the bank—his total debt (122% of equity). But debt isn’t his only obligation. He owes suppliers $15,500 for leather already delivered, committed to $5,000 in lease payments, and carries $2,500 in other liabilities. His total liabilities equal $31,000 (the $12,200 debt plus $18,800 in other obligations)—3.1 times his $10,000 equity.
Rocco owns $10,000 but owes $31,000.
Last year, his shops brought in $100,000 in sales. At year-end, he showed $3,000 in net income. On his $10,000 equity, that’s 30% return on equity—impressive!
But here’s what actually happens. When Rocco sells $10,000 worth of shoes, after paying for leather and materials, he keeps $1,200 as gross profit—his gross profit margin of 12%. From every $100 in sales, just $12 remains after cost of goods.
From that $1,200, he still pays rent and utilities ($700), wages ($300), and other operating costs ($170). After everything, $300 remains as net income—a net income margin of 3%. Out of every $100 in sales, just $3 is profit on paper.
But profit isn’t cash. After Rocco sets aside money to maintain equipment, he has $130 in actual cash. That’s his free cash flow—just 1.3% of revenue (FCF/Revenue). Out of every $10,000 in sales, only $130 remains as cash Rocco can actually use to pay debt, save, or reinvest.
Here’s where the illusion becomes clear. Rocco’s annual net income is $3,000, and his long-term bank debt is $3,000. His net income to long-term debt coverage is 1x—theoretically, he could pay off the bank loan in just one year from annual profit. That sounds really manageable and is actually a positive sign.
But his actual free cash flow is only $1,300 annually. Even dedicating every dollar to debt (taking nothing home, reinvesting nothing), he’d need over two years to clear his $3,000 long-term bank debt—and that doesn’t touch the remaining $28,000 in other liabilities.
Rocco’s liquidity situation is tight. His current assets—cash in the register plus inventory he could sell soon—total $32,604. His current liabilities—supplier bills, lease payments, and wages owed that are due in the short term—total $27,441. His current ratio is 1.19, meaning he has $1.19 in current assets for every $1.00 in current liabilities. For a business generating barely 1.3% free cash flow and carrying $31,000 in total liabilities, that’s almost no cushion. One bad quarter and he’s scrambling. Imagine Rocco lying awake knowing one slow month could unravel everything.
And his retained earnings tell a troubling story. Over the past five years, Rocco’s retained earnings—the cumulative profit kept in the business—grew just 0.5% annually, down from 8.6% previously. He’s retaining far less, signaling deteriorating profitability with less left to reinvest.
Rocco’s complete picture: 30-36% ROE (impressive!), but only 1.3% free cash flow generation (terrible). Razor-thin margins (12% gross, 3% net). Owes $31,000 while owning $10,000 (heavily leveraged). Retained earnings growth collapsed from 8.6% to 0.5% (deteriorating). Barely covers short-term obligations with 1.2 current ratio (tight liquidity).
That impressive ROE comes from borrowing heavily to amplify returns on a small equity base—not from operational excellence.
Compare Rocco to Marco, who runs a healthy shoemaker business. Marco started with the same $10,000 equity but borrowed only $3,000 (30% of equity, not 122%). His total liabilities are $8,000 (0.8x equity, not 3.1x). He generates 20% free cash flow—from $10,000 in sales, Marco keeps $2,000 in actual cash (not $130). His current ratio is 2.5. His retained earnings grow at 12% annually. Marco’s ROE is only 18%—but his business is built on strength, not leverage. Lower returns, infinitely more stable.
The lesson: High ROE means nothing without examining how it’s generated. Is it operational excellence with strong cash flow and minimal leverage? Or mediocre operations amplified by heavy borrowing?
Rocco’s 30-36% ROE paired with 1.3% free cash flow, 122% debt-to-equity, collapsing retained earnings, and barely adequate liquidity reveals that impressive return masks fragility. The 1x long-term debt coverage is deceptive—it hides that he generates so little free cash he has no margin for error.
What should Rocco do? Stop expanding. Pay down the $31,000 in liabilities aggressively. Improve cash generation—better pricing, reduced waste, faster inventory turns. Even reaching 3% free cash flow would double his stability. Build liquidity cushion—get current ratio from 1.2 to 1.8 minimum. Improve margins through operational excellence, not financial engineering.
The goal isn’t 30% ROE through leverage—it’s building a business generating strong cash, operating with manageable debt, and having room to survive mistakes. Lower returns on solid foundation beat high returns on a house of cards.
When you see impressive ROE numbers, dig deeper. What’s the free cash flow generation? The debt load? The liquidity? Are margins strong or thin? Is the business retaining and reinvesting successfully? If leverage is doing all the work while fundamentals remain weak, you’re looking at an illusion.
Rocco’s business might survive for years—but it’s not the exceptional business that 30-36% ROE suggests. It’s thin-margin, cash-light, highly-leveraged, where everything must go right just to keep functioning. That’s the difference between numbers that impress and businesses that endure.
This analysis is for educational purposes only and does not constitute financial advice. I am not a licensed financial advisor. All investing involves risk of loss. Do your own research and consult a qualified professional before making investment decisions.