HMN Financial Inc (NASDAQ:HMNF) generated a below-average return on equity of 7.02% in the past 12 months, while its industry returned 7.15%. 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 HMNF’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of HMNF’s returns. Let me show you what I mean by this. See our latest analysis for HMNF

Peeling the layers of ROE – trisecting a company’s profitability

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if HMNF invests $1 in the form of equity, it will generate $0.07 in earnings from this. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.

Return on Equity = Net Profit ÷ Shareholders Equity

Returns are usually compared to costs to measure the efficiency of capital. HMNF’s cost of equity is 9.28%. Since HMNF’s return does not cover its cost, with a difference of -2.26%, this means its current use of equity is not efficient and not sustainable. Very simply, HMNF pays more 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

The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue HMNF can generate with its current asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable HMNF’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check HMNF’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 8.89%, which means HMNF still has headroom to take on more leverage in order to increase profits.

What this means for you:

Are you a shareholder? HMNF’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 HMNF still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.

Are you a potential investor? If HMNF has been on your watch list for a while, making an investment decision based on ROE alone is unwise. I recommend you do additional fundamental analysis by looking through our most recent infographic report on HMN Financial to help you make a more informed investment decision.

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.