Gujarat Fluorochemicals Limited (NSEI:GUJFLUORO) generated a below-average return on equity of 2.79% in the past 12 months, while its industry returned 14.34%. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into GUJFLUORO’s past performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of GUJFLUORO’s returns. View our latest analysis for Gujarat Fluorochemicals
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Gujarat Fluorochemicals’s profit relative to its shareholders’ equity. An ROE of 2.79% implies ₹0.03 returned on every ₹1 invested. 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
Returns are usually compared to costs to measure the efficiency of capital. Gujarat Fluorochemicals’s cost of equity is 13.40%. Given a discrepancy of -10.61% between return and cost, this indicated that Gujarat Fluorochemicals may be paying more for its capital than what it’s generating in return. ROE can be split up into three useful 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 shows how much revenue Gujarat Fluorochemicals 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 artificially increased through excessive borrowing, we should check Gujarat Fluorochemicals’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 37.63%, meaning Gujarat Fluorochemicals still has headroom to borrow debt to increase profits.
What this means for you:
Are you a shareholder? GUJFLUORO’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as GUJFLUORO 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%.