The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want a simplistic look at the return on Xinchen China Power Holdings Limited (HKG:1148) stock.

Xinchen China Power Holdings Limited’s (HKG:1148) most recent return on equity was a substandard 4.28% relative to its industry performance of 13.46% over the past year. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into 1148’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 1148’s returns. Let me show you what I mean by this. Check out our latest analysis for Xinchen China Power Holdings

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) weighs Xinchen China Power Holdings’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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. Xinchen China Power Holdings’s cost of equity is 17.80%. Since Xinchen China Power Holdings’s return does not cover its cost, with a difference of -13.52%, this means its current use of equity is not efficient and not sustainable. Very simply, Xinchen China Power Holdings 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 Xinchen China Power Holdings 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 Xinchen China Power Holdings currently has. Currently the debt-to-equity ratio stands at a reasonable 60.80%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.