Soup Restaurant Group Limited (SGX:5KI) delivered an ROE of 14.97% over the past 12 months, which is an impressive feat relative to its industry average of 5.52% during the same period. Superficially, this looks great since we know that 5KI has generated big profits with little equity capital; however, ROE doesn’t tell us how much 5KI has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of 5KI’s ROE. Check out our latest analysis for Soup Restaurant Group
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Soup Restaurant Group’s profit relative to its shareholders’ equity. For example, if the company invests SGD1 in the form of equity, it will generate SGD0.15 in earnings from this. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.
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 Soup Restaurant Group, which is 8.45%. Since Soup Restaurant Group’s return covers its cost in excess of 6.52%, its use of equity capital is efficient and likely to be sustainable. Simply put, Soup Restaurant Group 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from Soup Restaurant Group’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Soup Restaurant Group currently has. Currently Soup Restaurant Group has virtually no debt, which means its returns are predominantly driven by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.