With an ROE of 12.01%, First Sponsor Group Limited (SGX:ADN) outpaced its own industry which delivered a less exciting 7.37% over the past year. While the impressive ratio tells us that ADN has made significant profits from little equity capital, ROE doesn’t tell us if ADN has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of ADN’s ROE. Check out our latest analysis for First Sponsor Group

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) weighs First Sponsor Group’s profit against the level of 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 First Sponsor Group’s equity capital deployed. Its cost of equity is 8.65%. Since First Sponsor Group’s return covers its cost in excess of 3.36%, its use of equity capital is efficient and likely to be sustainable. Simply put, First Sponsor Group 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

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 First Sponsor Group 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 financial leverage can artificially inflate ROE, we need to look at how much debt First Sponsor Group currently has. Currently the debt-to-equity ratio stands at a low 48.94%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.

What this means for you:

Are you a shareholder? ADN’s ROE is impressive relative to the industry average and also covers its cost of equity. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.

Are you a potential investor? If ADN has been on your watch list for a while, making an investment decision based on ROE alone is unwise. I recommend you do additional fundamental analysis by looking through our most recent infographic report on First Sponsor Group to help you make a more informed investment decision.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.