With an ROE of 78.13%, Swee Hong Limited (SGX:QF6) outpaced its own industry which delivered a less exciting 8.42% over the past year. While the impressive ratio tells us that QF6 has made significant profits from little equity capital, ROE doesn’t tell us if QF6 has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of QF6’s ROE. See our latest analysis for Swee Hong
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Swee Hong’s profit against the level of its shareholders’ equity. For example, if the company invests SGD1 in the form of equity, it will generate SGD0.78 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 Swee Hong’s equity capital deployed. Its cost of equity is 8.58%. This means Swee Hong returns enough to cover its own cost of equity, with a buffer of 69.55%. 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue Swee Hong can make from its asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check Swee Hong’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a balanced 127.62%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
What this means for you:
Are you a shareholder? QF6’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of QF6 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%.