Wellcom Group Limited (ASX:WLL) outperformed the Commercial Printing industry on the basis of its ROE – producing a higher 16.36% relative to the peer average of 9.08% over the past 12 months. Superficially, this looks great since we know that WLL has generated big profits with little equity capital; however, ROE doesn’t tell us how much WLL has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of WLL’s ROE. See our latest analysis for Wellcom Group

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 A$1 in the form of equity, it will generate A$0.16 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. Wellcom Group’s cost of equity is 8.55%. This means Wellcom Group returns enough to cover its own cost of equity, with a buffer of 7.81%. This sustainable practice implies that the company pays less for its capital than what it generates 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 Wellcom Group can generate with its current 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 ROE can be inflated by excessive debt, we need to examine Wellcom Group’s debt-to-equity level. Currently Wellcom 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.