New Zealand King Salmon Investments Limited (NZSE:NZK) outperformed the Packaged Foods and Meats industry on the basis of its ROE – producing a higher 17.38% relative to the peer average of 14.32% over the past 12 months. While the impressive ratio tells us that NZK has made significant profits from little equity capital, ROE doesn’t tell us if NZK has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of NZK’s ROE. See our latest analysis for New Zealand King Salmon Investments

What you must know about ROE

Return on Equity (ROE) weighs New Zealand King Salmon Investments’s profit against the level of its shareholders’ equity. An ROE of 17.38% implies NZ$0.17 returned on every NZ$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 New Zealand King Salmon Investments, which is 8.55%. Since New Zealand King Salmon Investments’s return covers its cost in excess of 8.83%, its use of equity capital is efficient and likely to be sustainable. Simply put, New Zealand King Salmon Investments pays less for its capital than what it generates in return. 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

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue New Zealand King Salmon Investments 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 New Zealand King Salmon Investments’s debt-to-equity level. Currently the debt-to-equity ratio stands at a low 7.32%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.