With an ROE of 15.68%, Siemens Limited (NSEI:SIEMENS) outpaced its own industry which delivered a less exciting 13.09% over the past year. On the surface, this looks fantastic since we know that SIEMENS has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable SIEMENS’s ROE is. Check out our latest analysis for Siemens

Breaking down Return on Equity

Return on Equity (ROE) weighs Siemens’s profit against the level of its shareholders’ equity. For example, if the company invests ₹1 in the form of equity, it will generate ₹0.16 in earnings from this. 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. Siemens’s cost of equity is 13.40%. This means Siemens returns enough to cover its own cost of equity, with a buffer of 2.28%. 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 reveals how much revenue can be generated from Siemens’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 ROE can be inflated by excessive debt, we need to examine Siemens’s debt-to-equity level. Currently, Siemens has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Siemens’s above-industry ROE is encouraging, and is also in excess of 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.