With an ROE of 25.50%, The Hackett Group Inc (NASDAQ:HCKT) outpaced its own industry which delivered a less exciting 13.32% over the past year. Superficially, this looks great since we know that HCKT has generated big profits with little equity capital; however, ROE doesn’t tell us how much HCKT has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable HCKT’s ROE is. See our latest analysis for Hackett Group

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) is a measure of Hackett Group’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. 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 Hackett Group’s equity capital deployed. Its cost of equity is 9.51%. Since Hackett Group’s return covers its cost in excess of 15.99%, its use of equity capital is efficient and likely to be sustainable. Simply put, Hackett Group 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

Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue Hackett Group can generate with its current asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt Hackett Group currently has. At 17.71%, Hackett Group’s debt-to-equity ratio appears low and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Hackett Group’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. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.