Sin Heng Heavy Machinery Limited’s (SGX:BKA) most recent return on equity was a substandard 1.33% relative to its industry performance of 5.04% over the past year. Though BKA’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 BKA’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of BKA’s returns. See our latest analysis for Sin Heng Heavy Machinery
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Sin Heng Heavy Machinery’s profit relative to its shareholders’ equity. For example, if the company invests SGD1 in the form of equity, it will generate SGD0.01 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 measured against cost of equity in order to determine the efficiency of Sin Heng Heavy Machinery’s equity capital deployed. Its cost of equity is 10.87%. Since Sin Heng Heavy Machinery’s return does not cover its cost, with a difference of -9.55%, this means its current use of equity is not efficient and not sustainable. Very simply, Sin Heng Heavy Machinery pays more 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. Asset turnover shows how much revenue Sin Heng Heavy Machinery can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Sin Heng Heavy Machinery’s debt-to-equity level. At 51.07%, Sin Heng Heavy Machinery’s debt-to-equity ratio appears sensible and indicates its ROE is generated from its capacity to increase profit without a large debt burden.
What this means for you:
Are you a shareholder? BKA’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as BKA still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. 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%.