Chelyabinsk Forge-and-Press Plant Public Joint Stock Company (MISX:CHKZ) delivered a less impressive 6.16% ROE over the past year, compared to the 13.24% return generated by its industry. CHKZ’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 CHKZ’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of CHKZ’s returns. View our latest analysis for Chelyabinsk Forge-and-Press Plant

What you must know about ROE

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 6.16% implies RUB0.06 returned on every RUB1 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. Chelyabinsk Forge-and-Press Plant’s cost of equity is 22.95%. Since Chelyabinsk Forge-and-Press Plant’s return does not cover its cost, with a difference of -16.79%, this means its current use of equity is not efficient and not sustainable. Very simply, Chelyabinsk Forge-and-Press Plant pays more for its capital than what it generates in return. 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

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 Chelyabinsk Forge-and-Press Plant can make from its 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 financial leverage can artificially inflate ROE, we need to look at how much debt Chelyabinsk Forge-and-Press Plant currently has. The debt-to-equity ratio currently stands at a high 221.60%, meaning the below-average ratio is already being driven by a large amount of debt.

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Chelyabinsk Forge-and-Press Plant’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.