With an ROE of 12.10%, China Jinjiang Environment Holding Company Limited (SGX:BWM) outpaced its own industry which delivered a less exciting 6.96% over the past year. While the impressive ratio tells us that BWM has made significant profits from little equity capital, ROE doesn’t tell us if BWM has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable BWM’s ROE is. See our latest analysis for China Jinjiang Environment Holding
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 SGD1 in the form of equity, it will generate SGD0.12 in earnings from this. 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
Returns are usually compared to costs to measure the efficiency of capital. China Jinjiang Environment Holding’s cost of equity is 8.74%. This means China Jinjiang Environment Holding returns enough to cover its own cost of equity, with a buffer of 3.36%. This sustainable practice implies that the company pays less for its capital than what it generates in return. ROE can be broken down into three different 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 China Jinjiang Environment Holding can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt China Jinjiang Environment Holding currently has. The debt-to-equity ratio currently stands at a balanced 103.45%, 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. China Jinjiang Environment Holding’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. Although ROE can be a useful metric, it is only a small part of diligent research.