Sanwaria Consumer Limited (NSEI:SANWARIA) generated a below-average return on equity of 11.25% in the past 12 months, while its industry returned 12.29%. Though SANWARIA’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on SANWARIA’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of SANWARIA’s returns. Check out our latest analysis for Sanwaria Consumer
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Sanwaria Consumer’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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
ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Sanwaria Consumer, which is 14.75%. Given a discrepancy of -3.50% between return and cost, this indicated that Sanwaria Consumer may be paying more for its capital than what it’s generating 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. The other component, asset turnover, illustrates how much revenue Sanwaria Consumer can make from its 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 financial leverage can artificially inflate ROE, we need to look at how much debt Sanwaria Consumer currently has. The debt-to-equity ratio currently stands at a high 221.17%, meaning the below-average ratio is already being driven by a large amount of debt.
What this means for you:
Are you a shareholder? SANWARIA’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Additionally, its high debt level appears to be a key driver of its ROE and is something you should be mindful of before adding more of SANWARIA to your portfolio. 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%.