XRF Scientific Limited (ASX:XRF) delivered a less impressive 2.58% ROE over the past year, compared to the 12.36% return generated by its industry. Though XRF’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 XRF’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of XRF’s returns. View our latest analysis for XRF Scientific
Breaking down Return on Equity
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests A$1 in the form of equity, it will generate A$0.03 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
ROE is measured against cost of equity in order to determine the efficiency of XRF Scientific’s equity capital deployed. Its cost of equity is 8.66%. Since XRF Scientific’s return does not cover its cost, with a difference of -6.07%, this means its current use of equity is not efficient and not sustainable. Very simply, XRF Scientific 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. Asset turnover reveals how much revenue can be generated from XRF Scientific’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 XRF Scientific’s debt-to-equity level. At 4.07%, XRF Scientific’s debt-to-equity ratio appears low and indicates that XRF Scientific still has room to increase leverage and grow its profits.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. XRF Scientific’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of XRF Scientific’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.