China Jishan Holdings Limited (SGX:J18) outperformed the Textiles industry on the basis of its ROE – producing a higher 13.48% relative to the peer average of 9.91% over the past 12 months. While the impressive ratio tells us that J18 has made significant profits from little equity capital, ROE doesn’t tell us if J18 has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether J18’s ROE is actually sustainable. See our latest analysis for China Jishan Holdings
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs China Jishan Holdings’s profit against the level of its shareholders’ equity. An ROE of 13.48% implies SGD0.13 returned on every SGD1 invested. 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. China Jishan Holdings’s cost of equity is 9.46%. Given a positive discrepancy of 4.02% between return and cost, this indicates that China Jishan Holdings pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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. Asset turnover shows how much revenue China Jishan Holdings can generate with its current 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 China Jishan Holdings currently has. At 203.58%, China Jishan Holdings’s debt-to-equity ratio appears relatively high and indicates the above-average ROE is generated by significant leverage levels.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. China Jishan Holdings exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of China Jishan Holdings’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.