Equitable Financial Corp (NASDAQ:EQFN) delivered a less impressive 3.45% ROE over the past year, compared to the 7.15% return generated by its industry. EQFN'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 EQFN’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of EQFN's returns. Check out our latest analysis for Equitable Financial

Breaking down ROE — the mother of all ratios

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if EQFN invests $1 in the form of equity, it will generate $0.03 in earnings from this. 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

ROE is measured against cost of equity in order to determine the efficiency of EQFN’s equity capital deployed. Its cost of equity is 9.21%. Given a discrepancy of -5.76% between return and cost, this indicated that EQFN may be paying more for its capital than what it’s generating 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

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient EQFN is with its cost management. Asset turnover shows how much revenue EQFN can generate with its current asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable EQFN’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check EQFN’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 20.09%, meaning EQFN still has headroom to borrow debt to increase profits.

What this means for you:

Are you a shareholder? EQFN’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as EQFN still has capacity to improve shareholder returns by borrowing to invest in new projects in the future.

Are you a potential investor? If you are considering investing in EQFN, basing your decision on ROE alone is certainly not sufficient. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Equitable Financial to help you make a more informed investment decision. If you are not interested in EQFN anymore, you can use our free platform to see our list of stocks with Return on Equity over 20%.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.