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.