Shanghai Qingpu fire-fighting equipment Co Ltd (SEHK:8115) generated a below-average return on equity of 1.77% in the past 12 months, while its industry returned 11.22%. 8115’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 8115’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of 8115’s returns. View our latest analysis for Shanghai Qingpu fire-fighting equipment
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Shanghai Qingpu fire-fighting equipment’s profit relative to its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.02 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. Shanghai Qingpu fire-fighting equipment’s cost of equity is 8.38%. This means Shanghai Qingpu fire-fighting equipment’s returns actually do not cover its own cost of equity, with a discrepancy of -6.60%. This isn’t sustainable as it implies, very simply, that the company pays more 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
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 Shanghai Qingpu fire-fighting equipment 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 Shanghai Qingpu fire-fighting equipment currently has. The debt-to-equity ratio currently stands at a low 10.94%, meaning Shanghai Qingpu fire-fighting equipment still has headroom to borrow debt to increase profits.