SQS India BFSI Limited (NSEI:SQSBFSI) outperformed the IT Consulting and Other Services industry on the basis of its ROE – producing a higher 20.07% relative to the peer average of 14.92% over the past 12 months. While the impressive ratio tells us that SQSBFSI has made significant profits from little equity capital, ROE doesn’t tell us if SQSBFSI has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable SQSBFSI’s ROE is. Check out our latest analysis for SQS India BFSI
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 ₹0.2 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 measured against cost of equity in order to determine the efficiency of SQS India BFSI’s equity capital deployed. Its cost of equity is 13.40%. Since SQS India BFSI’s return covers its cost in excess of 6.67%, its use of equity capital is efficient and likely to be sustainable. Simply put, SQS India BFSI pays less 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 SQS India BFSI 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 SQS India BFSI currently has. Currently, SQS India BFSI has no debt which means its returns are driven purely 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.
What this means for you:
Are you a shareholder? SQSBFSI exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of SQSBFSI to your portfolio if your personal research is confirming what the ROE is telling you. 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%.