This article is intended for those of you who are at the beginning of your investing journey and want a simplistic look at the return on Rico Auto Industries Limited (NSE:RICOAUTO) stock.
Rico Auto Industries Limited (NSE:RICOAUTO) delivered a less impressive 10.24% ROE over the past year, compared to the 13.75% return generated by its industry. RICOAUTO’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 RICOAUTO’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of RICOAUTO’s returns. Let me show you what I mean by this. View out our latest analysis for Rico Auto Industries
What you must know about ROE
Return on Equity (ROE) is a measure of Rico Auto Industries’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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
ROE is measured against cost of equity in order to determine the efficiency of Rico Auto Industries’s equity capital deployed. Its cost of equity is 13.55%. Given a discrepancy of -3.31% between return and cost, this indicated that Rico Auto Industries may be paying more for its capital than what it’s generating 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
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 reveals how much revenue can be generated from Rico Auto Industries’s 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 financial leverage can artificially inflate ROE, we need to look at how much debt Rico Auto Industries currently has. The debt-to-equity ratio currently stands at a low 34.97%, meaning Rico Auto Industries still has headroom to borrow debt to increase profits.