With an ROE of 24.61%, Fabryka Farb i Lakierów Sniezka SA (WSE:SKA) outpaced its own industry which delivered a less exciting 8.13% over the past year. Superficially, this looks great since we know that SKA has generated big profits with little equity capital; however, ROE doesn’t tell us how much SKA has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable SKA’s ROE is. See our latest analysis for Fabryka Farb i Lakierów Sniezka

Breaking down Return on Equity

Return on Equity (ROE) weighs Fabryka Farb i Lakierów Sniezka’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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

ROE is measured against cost of equity in order to determine the efficiency of Fabryka Farb i Lakierów Sniezka’s equity capital deployed. Its cost of equity is 8.67%. Given a positive discrepancy of 15.94% between return and cost, this indicates that Fabryka Farb i Lakierów Sniezka pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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

The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from Fabryka Farb i Lakierów Sniezka’s 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 artificially increased through excessive borrowing, we should check Fabryka Farb i Lakierów Sniezka’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 33.01%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Fabryka Farb i Lakierów Sniezka exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.