Ossia International Limited’s (SGX:O08) most recent return on equity was a substandard 1.13% relative to its industry performance of 6.98% over the past year. O08’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on O08’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of O08’s returns. Check out our latest analysis for Ossia International
Peeling the layers of ROE – trisecting a company’s profitability
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 1.13% implies SGD0.01 returned on every SGD1 invested. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Ossia International’s equity capital deployed. Its cost of equity is 8.38%. Given a discrepancy of -7.25% between return and cost, this indicated that Ossia International may be paying more for its capital than what it’s generating 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from Ossia International’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Ossia International currently has. The debt-to-equity ratio currently stands at a low 23.34%, meaning Ossia International still has headroom to borrow debt to increase profits.
What this means for you:
Are you a shareholder? O08’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means O08 still has room to improve shareholder returns by raising debt to fund new investments. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.