With an ROE of 20.72%, Liv Ihop AB (OM:LIVI) outpaced its own industry which delivered a less exciting 11.32% over the past year. Superficially, this looks great since we know that LIVI has generated big profits with little equity capital; however, ROE doesn’t tell us how much LIVI has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable LIVI’s ROE is. Check out our latest analysis for Liv Ihop
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Liv Ihop’s profit relative to its shareholders’ equity. An ROE of 20.72% implies SEK0.21 returned on every SEK1 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
Returns are usually compared to costs to measure the efficiency of capital. Liv Ihop’s cost of equity is 9.75%. Given a positive discrepancy of 10.96% between return and cost, this indicates that Liv Ihop pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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
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 Liv Ihop’s 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 ROE can be inflated by excessive debt, we need to examine Liv Ihop’s debt-to-equity level. The debt-to-equity ratio currently stands at a high 152.36%, meaning the above-average ratio is a result of a large amount of debt.
Next Steps:
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses of a company. Liv Ihop’s ROE is impressive relative to the industry average and also covers its cost of equity. With debt capital in excess of equity, ROE may be inflated by the use of debt funding, raising questions over the sustainability of the company’s returns. Although ROE can be a useful metric, it is only a small part of diligent research.