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Yangzijiang Shipbuilding (Holdings) Ltd (SGX:BS6) delivered an ROE of 11.66% over the past 12 months, which is an impressive feat relative to its industry average of 7.34% during the same period. Superficially, this looks great since we know that BS6 has generated big profits with little equity capital; however, ROE doesn’t tell us how much BS6 has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable BS6’s ROE is. Check out our latest analysis for Yangzijiang Shipbuilding (Holdings)
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Yangzijiang Shipbuilding (Holdings)’s profit relative to its shareholders’ equity. For example, if the company invests SGD1 in the form of equity, it will generate SGD0.12 in earnings from this. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Yangzijiang Shipbuilding (Holdings)’s equity capital deployed. Its cost of equity is 9.88%. Given a positive discrepancy of 1.78% between return and cost, this indicates that Yangzijiang Shipbuilding (Holdings) pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
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 Yangzijiang Shipbuilding (Holdings) 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 Yangzijiang Shipbuilding (Holdings)’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 18.44%, 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. Yangzijiang Shipbuilding (Holdings) exhibits a strong ROE against its peers, as well as sufficient returns to cover its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. Although ROE can be a useful metric, it is only a small part of diligent research.