Global Testing Corporation Limited (SGX:AYN) generated a below-average return on equity of 6.37% in the past 12 months, while its industry returned 12.55%. Though AYN’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 AYN’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of AYN’s returns. Check out our latest analysis for Global Testing

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. For example, if the company invests SGD1 in the form of equity, it will generate SGD0.06 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

Returns are usually compared to costs to measure the efficiency of capital. Global Testing’s cost of equity is 8.96%. This means Global Testing’s returns actually do not cover its own cost of equity, with a discrepancy of -2.59%. 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. Asset turnover reveals how much revenue can be generated from Global Testing’s 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 Global Testing currently has. Currently, Global Testing has no debt which means its returns are driven purely by equity capital. This could explain why Global Testing’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.