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With an ROE of 14.12%, Sinopharm Group Co Ltd. (SEHK:1099) outpaced its own industry which delivered a less exciting 9.33% over the past year. While the impressive ratio tells us that 1099 has made significant profits from little equity capital, ROE doesn’t tell us if 1099 has borrowed debt to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether 1099’s ROE is actually sustainable. See our latest analysis for Sinopharm Group
Breaking down Return on Equity
Return on Equity (ROE) is a measure of Sinopharm Group’s profit relative to its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.14 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 Sinopharm Group’s equity capital deployed. Its cost of equity is 8.44%. Since Sinopharm Group’s return covers its cost in excess of 5.68%, its use of equity capital is efficient and likely to be sustainable. Simply put, Sinopharm Group 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 Sinopharm Group’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 financial leverage can artificially inflate ROE, we need to look at how much debt Sinopharm Group currently has. At 61.59%, Sinopharm Group’s debt-to-equity ratio appears sensible and indicates the above-average ROE is generated from its capacity to increase profit without a large debt burden.
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ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Sinopharm Group’s ROE is impressive relative to the industry average and also covers its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.