With an ROE of 13.78%, China Maple Leaf Educational Systems Limited (SEHK:1317) outpaced its own industry which delivered a less exciting 13.11% over the past year. Superficially, this looks great since we know that 1317 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 1317 has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of 1317’s ROE. Check out our latest analysis for China Maple Leaf Educational Systems

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) weighs China Maple Leaf Educational Systems’s profit against the level of its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.14 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 measured against cost of equity in order to determine the efficiency of China Maple Leaf Educational Systems’s equity capital deployed. Its cost of equity is 13.74%. This means China Maple Leaf Educational Systems returns enough to cover its own cost of equity, with a buffer of 0.039%. This sustainable practice implies that the company pays less 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

The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue China Maple Leaf Educational Systems can generate with its current 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 inflated by excessive debt, we need to examine China Maple Leaf Educational Systems’s debt-to-equity level. At 12.04%, China Maple Leaf Educational Systems’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. China Maple Leaf Educational Systems 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. Although ROE can be a useful metric, it is only a small part of diligent research.