With an ROE of 31.78%, Swee Hong Limited (SGX:QF6) outpaced its own industry which delivered a less exciting 8.32% over the past year. While the impressive ratio tells us that QF6 has made significant profits from little equity capital, ROE doesn’t tell us if QF6 has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable QF6’s ROE is. View our latest analysis for Swee Hong

Breaking down ROE — the mother of all ratios

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. An ROE of 31.78% implies SGD0.32 returned on every SGD1 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. Swee Hong’s cost of equity is 8.38%. Since Swee Hong’s return covers its cost in excess of 23.40%, its use of equity capital is efficient and likely to be sustainable. Simply put, Swee Hong pays less for its capital than what it generates in return. ROE can be dissected into three distinct 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 Swee Hong can generate with its current 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 Swee Hong’s debt-to-equity level. Currently the debt-to-equity ratio stands at a balanced 145.69%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.

Next Steps:

While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Swee Hong’s ROE is impressive relative to the industry average and also covers 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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.

For Swee Hong, I’ve compiled three pertinent factors you should further examine:

1. Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.

2. Future Earnings: How does Swee Hong’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.

3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Swee Hong? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.