Jamna Auto Industries Limited (NSEI:JAMNAAUTO) outperformed the Auto Parts and Equipment industry on the basis of its ROE – producing a higher 31.48% relative to the peer average of 12.81% over the past 12 months. While the impressive ratio tells us that JAMNAAUTO has made significant profits from little equity capital, ROE doesn’t tell us if JAMNAAUTO has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether JAMNAAUTO’s ROE is actually sustainable. See our latest analysis for Jamna Auto Industries
What you must know about ROE
Return on Equity (ROE) is a measure of Jamna Auto Industries’s profit relative to its shareholders’ equity. An ROE of 31.48% implies ₹0.31 returned on every ₹1 invested. 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. Jamna Auto Industries’s cost of equity is 13.40%. Since Jamna Auto Industries’s return covers its cost in excess of 18.08%, its use of equity capital is efficient and likely to be sustainable. Simply put, Jamna Auto Industries 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 Jamna Auto Industries’s 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 Jamna Auto Industries’s debt-to-equity level. The debt-to-equity ratio currently stands at a sensible 65.27%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Jamna Auto Industries’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. Although ROE can be a useful metric, it is only a small part of diligent research.