Asia Enterprises Holding Limited (SGX:A55) generated a below-average return on equity of 1.25% in the past 12 months, while its industry returned 2.54%. Though A55’s recent performance is underwhelming, it is useful to understand what ROE is made up of and how it should be interpreted. Knowing these components can change your views on A55’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of A55’s returns. View our latest analysis for Asia Enterprises Holding

What you must know about ROE

Return on Equity (ROE) weighs Asia Enterprises Holding’s profit against the level of its shareholders’ equity. An ROE of 1.25% implies SGD0.01 returned on every SGD1 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

ROE is measured against cost of equity in order to determine the efficiency of Asia Enterprises Holding’s equity capital deployed. Its cost of equity is 8.38%. Given a discrepancy of -7.13% between return and cost, this indicated that Asia Enterprises Holding may be paying more for its capital than what it’s generating 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. The other component, asset turnover, illustrates how much revenue Asia Enterprises Holding 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 Asia Enterprises Holding’s debt-to-equity level. Currently, Asia Enterprises Holding has no debt which means its returns are driven purely by equity capital. This could explain why Asia Enterprises Holding’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Asia Enterprises Holding exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Asia Enterprises Holding’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.