With an ROE of 9.36%, Financial Institutions Inc (NASDAQ:FISI) outpaced its own industry which delivered a less exciting 8.95% over the past year. While the impressive ratio tells us that FISI has made significant profits from little equity capital, ROE doesn’t tell us if FISI has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable FISI’s ROE is. View our latest analysis for Financial Institutions

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) weighs FISI’s profit against the level of its shareholders’ equity. For example, if FISI invests $1 in the form of equity, it will generate $0.09 in earnings from this. 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 measured against cost of equity in order to determine the efficiency of FISI’s equity capital deployed. Its cost of equity is 11.02%. Given a discrepancy of -1.66% between return and cost, this indicated that FISI may be paying more for its capital than what it’s generating in return. 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

The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue FISI can generate with its current 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 FISI’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt FISI currently has. The debt-to-equity ratio currently stands at a balanced 111.21%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.

What this means for you:

Are you a shareholder? FISI’s ROE is impressive relative to the industry average, though its returns were not strong enough to cover its own cost of equity. However, investors shouldn’t despair since ROE is not inflated by excessive debt, which means FISI still has room to improve shareholder returns by raising debt to fund new investments.