Asseco Business Solutions SA (WSE:ABS) delivered an ROE of 17.93% over the past 12 months, which is an impressive feat relative to its industry average of 14.22% during the same period. Superficially, this looks great since we know that ABS has generated big profits with little equity capital; however, ROE doesn’t tell us how much ABS has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether ABS’s ROE is actually sustainable. View our latest analysis for Asseco Business Solutions
Breaking down Return on Equity
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 PLN1 in the form of equity, it will generate PLN0.18 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 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 Asseco Business Solutions, which is 8.67%. Given a positive discrepancy of 9.26% between return and cost, this indicates that Asseco Business Solutions pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue Asseco Business Solutions can generate with its current 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 inflated by excessive debt, we need to examine Asseco Business Solutions’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 11.59%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.