Cinda International Holdings Limited’s (SEHK:111) most recent return on equity was a substandard 7.57% relative to its industry performance of 8.97% over the past year. Though 111’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 111’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 111’s returns. Let me show you what I mean by this. See our latest analysis for Cinda International Holdings
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of Cinda International Holdings’s profit relative to its shareholders’ equity. An ROE of 7.57% implies HK$0.08 returned on every HK$1 invested. 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
ROE is measured against cost of equity in order to determine the efficiency of Cinda International Holdings’s equity capital deployed. Its cost of equity is 10.38%. Since Cinda International Holdings’s return does not cover its cost, with a difference of -2.81%, this means its current use of equity is not efficient and not sustainable. Very simply, Cinda International Holdings 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 reveals how much revenue can be generated from Cinda International Holdings’s 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 ROE can be inflated by excessive debt, we need to examine Cinda International Holdings’s debt-to-equity level. At 102.49%, Cinda International Holdings’s debt-to-equity ratio appears balanced and indicates its ROE is generated from its capacity to increase profit without a large debt burden.
Next Steps:
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Cinda International Holdings’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. Although ROE can be a useful metric, it is only a small part of diligent research.