With an ROE of 13.66%, Nordfyns Bank A/S (CPSE:NRDF) outpaced its own industry which delivered a less exciting 9.66% over the past year. Superficially, this looks great since we know that NRDF has generated big profits with little equity capital; however, ROE doesn’t tell us how much NRDF has borrowed in debt. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable NRDF’s ROE is. View our latest analysis for Nordfyns Bank
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. An ROE of 13.66% implies DKK0.14 returned on every DKK1 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. Nordfyns Bank’s cost of equity is 8.15%. Since Nordfyns Bank’s return covers its cost in excess of 5.51%, its use of equity capital is efficient and likely to be sustainable. Simply put, Nordfyns Bank pays less for its capital than what it generates in return. ROE can be broken down into three different 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover reveals how much revenue can be generated from Nordfyns Bank’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt Nordfyns Bank currently has. Currently the debt-to-equity ratio stands at a low 28.38%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.
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. Nordfyns Bank’s ROE is impressive relative to the industry average and also covers its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. Although ROE can be a useful metric, it is only a small part of diligent research.