Pankl Racing Systems AG’s (WBAG:PARS) most recent return on equity was a substandard 6.28% relative to its industry performance of 14.06% over the past year. PARS’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 PARS’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of PARS’s returns. View our latest analysis for Pankl Racing Systems
Breaking down Return on Equity
Return on Equity (ROE) weighs Pankl Racing Systems’s profit against the level of its shareholders’ equity. For example, if the company invests €1 in the form of equity, it will generate €0.06 in earnings from this. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Pankl Racing Systems’s cost of equity is 16.24%. Since Pankl Racing Systems’s return does not cover its cost, with a difference of -9.96%, this means its current use of equity is not efficient and not sustainable. Very simply, Pankl Racing Systems 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. The other component, asset turnover, illustrates how much revenue Pankl Racing Systems can make from its 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 financial leverage can artificially inflate ROE, we need to look at how much debt Pankl Racing Systems currently has. The debt-to-equity ratio currently stands at a balanced 107.75%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.