Chromatic India Limited’s (NSEI:CHROMATIC) most recent return on equity was a substandard 0.0003% relative to its industry performance of 14.63% over the past year. Though CHROMATIC’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on CHROMATIC’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of CHROMATIC’s returns. See our latest analysis for Chromatic India
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Chromatic India’s profit relative to its shareholders’ equity. An ROE of 0.0003% implies ₹0 returned on every ₹1 invested. 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
Returns are usually compared to costs to measure the efficiency of capital. Chromatic India’s cost of equity is 13.40%. This means Chromatic India’s returns actually do not cover its own cost of equity, with a discrepancy of -13.40%. 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 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. Asset turnover shows how much revenue Chromatic India 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 Chromatic India’s debt-to-equity level. At 1.16%, Chromatic India’s debt-to-equity ratio appears low and indicates that Chromatic India still has room to increase leverage and grow its profits.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Chromatic India exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. 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.