The Bombay Dyeing and Manufacturing Company Limited (NSEI:BOMDYEING) generated a below-average return on equity of 4.57% in the past 12 months, while its industry returned 6.98%. BOMDYEING’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 BOMDYEING’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of BOMDYEING’s returns. See our latest analysis for Bombay Dyeing and Manufacturing
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests ₹1 in the form of equity, it will generate ₹0.05 in earnings from this. 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 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 Bombay Dyeing and Manufacturing, which is 13.40%. Given a discrepancy of -8.83% between return and cost, this indicated that Bombay Dyeing and Manufacturing 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue Bombay Dyeing and Manufacturing can generate with its current 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 Bombay Dyeing and Manufacturing’s historic debt-to-equity ratio. At 219.67%, Bombay Dyeing and Manufacturing’s debt-to-equity ratio appears relatively high and indicates the below-average ROE is already being generated by significant leverage levels.