This analysis is intended to introduce important early concepts to people who are starting to invest and want to learn about Return on Equity using a real-life example.

Hock Lian Seng Holdings Limited (SGX:J2T) outperformed the Construction and Engineering industry on the basis of its ROE – producing a higher 11.3% relative to the peer average of 8.3% over the past 12 months. While the impressive ratio tells us that J2T has made significant profits from little equity capital, ROE doesn’t tell us if J2T has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether J2T’s ROE is actually sustainable.

Check out our latest analysis for Hock Lian Seng Holdings

Peeling the layers of ROE – trisecting a company’s profitability

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 Hock Lian Seng Holdings’s equity capital deployed. Its cost of equity is 8.5%. Since Hock Lian Seng Holdings’s return covers its cost in excess of 2.7%, its use of equity capital is efficient and likely to be sustainable. Simply put, Hock Lian Seng Holdings 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

The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from Hock Lian Seng Holdings’s 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 Hock Lian Seng Holdings currently has. Currently the debt-to-equity ratio stands at a low 7.3%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.