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With an ROE of 15.62%, Kitron ASA (OB:KIT) outpaced its own industry which delivered a less exciting 11.39% over the past year. Superficially, this looks great since we know that KIT has generated big profits with little equity capital; however, ROE doesn’t tell us how much KIT has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable KIT’s ROE is. See our latest analysis for Kitron
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. An ROE of 15.62% implies NOK0.16 returned on every NOK1 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
ROE is measured against cost of equity in order to determine the efficiency of Kitron’s equity capital deployed. Its cost of equity is 17.17%. This means Kitron’s returns actually do not cover its own cost of equity, with a discrepancy of -1.56%. This isn’t sustainable as it implies, very simply, that the company pays more 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Kitron can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Kitron’s debt-to-equity level. At 53.03%, Kitron’s debt-to-equity ratio appears sensible and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
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ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Kitron’s ROE is impressive relative to the industry average, though its returns were not strong enough to cover its own cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.