Independent Bank Corporation (NASDAQ:IBCP) delivered an ROE of 8.83% over the past 12 months, which is an impressive feat relative to its industry average of 8.46% during the same period. On the surface, this looks fantastic since we know that IBCP has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of IBCP’s ROE. View our latest analysis for Independent Bank

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) is a measure of Independent Bank’s profit relative to its shareholders’ equity. An ROE of 8.83% implies $0.09 returned on every $1 invested. 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 Independent Bank, which is 9.91%. This means Independent Bank’s returns actually do not cover its own cost of equity, with a discrepancy of -1.08%. This isn’t sustainable as it implies, very simply, that the company pays more 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 Independent Bank can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Independent Bank’s debt-to-equity level. At 24.44%, Independent Bank’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.