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With an ROE of 19.38%, Beijing Tong Ren Tang Chinese Medicine Company Limited (SEHK:8138) outpaced its own industry which delivered a less exciting 13.71% over the past year. On the surface, this looks fantastic since we know that 8138 has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of 8138’s ROE. See our latest analysis for Beijing Tong Ren Tang Chinese Medicine
What you must know about ROE
Return on Equity (ROE) weighs Beijing Tong Ren Tang Chinese Medicine’s profit against the level of its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.19 in earnings from this. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Beijing Tong Ren Tang Chinese Medicine’s cost of equity is 8.38%. This means Beijing Tong Ren Tang Chinese Medicine returns enough to cover its own cost of equity, with a buffer of 11.01%. This sustainable practice implies that the company pays less for its capital than what it generates in return. ROE can be dissected into three distinct ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
Dupont Formula
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from Beijing Tong Ren Tang Chinese Medicine’s asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine Beijing Tong Ren Tang Chinese Medicine’s debt-to-equity level. Currently Beijing Tong Ren Tang Chinese Medicine has virtually no debt, which means its returns are predominantly driven by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.