With an ROE of 20.65%, Solar Industries India Limited (NSEI:SOLARINDS) outpaced its own industry which delivered a less exciting 15.33% over the past year. While the impressive ratio tells us that SOLARINDS has made significant profits from little equity capital, ROE doesn’t tell us if SOLARINDS has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable SOLARINDS’s ROE is. See our latest analysis for Solar Industries India
What you must know about ROE
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 20.65% implies ₹0.21 returned on every ₹1 invested. 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
ROE is measured against cost of equity in order to determine the efficiency of Solar Industries India’s equity capital deployed. Its cost of equity is 13.40%. Since Solar Industries India’s return covers its cost in excess of 7.25%, its use of equity capital is efficient and likely to be sustainable. Simply put, Solar Industries India 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Solar Industries India 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 ROE can be inflated by excessive debt, we need to examine Solar Industries India’s debt-to-equity level. The debt-to-equity ratio currently stands at a low 34.29%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Solar Industries India exhibits a strong ROE against its peers, as well as sufficient returns to cover 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. Although ROE can be a useful metric, it is only a small part of diligent research.