With an ROE of 12.09%, Huon Aquaculture Group Limited (ASX:HUO) outpaced its own industry which delivered a less exciting 10.38% over the past year. Superficially, this looks great since we know that HUO has generated big profits with little equity capital; however, ROE doesn’t tell us how much HUO has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable HUO’s ROE is. Check out our latest analysis for Huon Aquaculture Group

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) is a measure of Huon Aquaculture Group’s profit relative to its shareholders’ equity. For example, if the company invests A$1 in the form of equity, it will generate A$0.12 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

Returns are usually compared to costs to measure the efficiency of capital. Huon Aquaculture Group’s cost of equity is 8.55%. Given a positive discrepancy of 3.54% between return and cost, this indicates that Huon Aquaculture Group pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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 Huon Aquaculture 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 Huon Aquaculture Group currently has. Currently the debt-to-equity ratio stands at a low 23.61%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Huon Aquaculture Group’s above-industry ROE is encouraging, and is also in excess of its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.