Boyuan Holdings Limited (ASX:BHL) generated a below-average return on equity of 0.54% in the past 12 months, while its industry returned 8.99%. BHL’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on BHL’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of BHL’s returns. Let me show you what I mean by this. See our latest analysis for Boyuan Holdings
Breaking down Return on Equity
Return on Equity (ROE) weighs Boyuan Holdings’s profit against the level of its shareholders’ equity. For example, if the company invests A$1 in the form of equity, it will generate A$0.01 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
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 Boyuan Holdings, which is 10.84%. This means Boyuan Holdings’s returns actually do not cover its own cost of equity, with a discrepancy of -10.30%. 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 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
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 Boyuan Holdings 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 Boyuan Holdings’s debt-to-equity level. Currently the debt-to-equity ratio stands at a balanced 102.27%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.