IASO SA.’s (ATSE:IASO) most recent return on equity was a substandard 6.91% relative to its industry performance of 11.70% over the past year. IASO’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on IASO’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of IASO’s returns. Let me show you what I mean by this. Check out our latest analysis for IASO

Breaking down ROE — the mother of all ratios

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests €1 in the form of equity, it will generate €0.07 in earnings from this. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.

Return on Equity = Net Profit ÷ Shareholders Equity

ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for IASO, which is 10.68%. Since IASO’s return does not cover its cost, with a difference of -3.77%, this means its current use of equity is not efficient and not sustainable. Very simply, IASO pays more for its capital than what it generates 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

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover shows how much revenue IASO 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 the company’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt IASO currently has. Currently the debt-to-equity ratio stands at a balanced 146.32%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.