With an ROE of 21.89%, JCurve Solutions Limited (ASX:JCS) outpaced its own industry which delivered a less exciting 20.59% over the past year. Superficially, this looks great since we know that JCS has generated big profits with little equity capital; however, ROE doesn’t tell us how much JCS has borrowed in debt. We’ll take a closer look today at factors like financial leverage to determine whether JCS’s ROE is actually sustainable. See our latest analysis for JCurve Solutions
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of JCurve Solutions’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. 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
Returns are usually compared to costs to measure the efficiency of capital. JCurve Solutions’s cost of equity is 12.26%. Given a positive discrepancy of 9.64% between return and cost, this indicates that JCurve Solutions pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be broken down into three different 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. Asset turnover shows how much revenue JCurve Solutions can generate with its current asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt JCurve Solutions currently has. Currently, JCurve Solutions 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 a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. JCurve Solutions’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.