This article is intended for those of you who are at the beginning of your investing journey and want to begin learning the link between company’s fundamentals and stock market performance.

IOL Chemicals and Pharmaceuticals Limited (NSE:IOLCP) outperformed the Commodity Chemicals industry on the basis of its ROE – producing a higher 18.14% relative to the peer average of 14.73% over the past 12 months. On the surface, this looks fantastic since we know that IOLCP has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of IOLCP’s ROE.

View our latest analysis for IOL Chemicals and Pharmaceuticals

Breaking down Return on Equity

Return on Equity (ROE) is a measure of IOL Chemicals and Pharmaceuticals’s profit relative to its shareholders’ equity. An ROE of 18.14% implies ₹0.18 returned on every ₹1 invested. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.

Return on Equity = Net Profit ÷ Shareholders Equity

ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for IOL Chemicals and Pharmaceuticals, which is 13.55%. This means IOL Chemicals and Pharmaceuticals returns enough to cover its own cost of equity, with a buffer of 4.59%. This sustainable practice implies that the company 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

Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue IOL Chemicals and Pharmaceuticals can make from its 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 IOL Chemicals and Pharmaceuticals’s debt-to-equity level. The debt-to-equity ratio currently stands at a high 182.34%, meaning the above-average ratio is a result of a large amount of debt.

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. IOL Chemicals and Pharmaceuticals’s ROE is impressive relative to the industry average and also covers its cost of equity. Its high debt level means its strong ROE may be driven by debt funding which raises concerns over the sustainability of IOL Chemicals and Pharmaceuticals’s returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.

For IOL Chemicals and Pharmaceuticals, there are three important aspects 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 IOL Chemicals and Pharmaceuticals’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 IOL Chemicals and Pharmaceuticals? 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 past 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. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.