Cadila Healthcare Limited (NSEI:CADILAHC) outperformed the Pharmaceuticals industry on the basis of its ROE – producing a higher 20.59% relative to the peer average of 11.43% over the past 12 months. On the surface, this looks fantastic since we know that CADILAHC has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable CADILAHC’s ROE is. Check out our latest analysis for Cadila Healthcare
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Cadila Healthcare’s profit relative to its shareholders’ equity. For example, if the company invests ₹1 in the form of equity, it will generate ₹0.21 in earnings from this. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Cadila Healthcare’s cost of equity is 13.40%. This means Cadila Healthcare returns enough to cover its own cost of equity, with a buffer of 7.19%. This sustainable practice implies that the company pays less for its capital than what it generates in return. ROE can be split up into three useful 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 Cadila Healthcare’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 artificially increased through excessive borrowing, we should check Cadila Healthcare’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a reasonable 62.54%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Cadila Healthcare’s above-industry ROE is encouraging, and is also in excess of its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.