This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.

Oceania Healthcare Limited (NZSE:OCA) outperformed the Health Care Facilities industry on the basis of its ROE – producing a higher 14.3% relative to the peer average of 12.5% over the past 12 months. While the impressive ratio tells us that OCA has made significant profits from little equity capital, ROE doesn’t tell us if OCA has borrowed debt to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable OCA’s ROE is.

Check out our latest analysis for Oceania Healthcare

Breaking down Return on Equity

Return on Equity (ROE) is a measure of Oceania Healthcare’s profit relative to its shareholders’ equity. An ROE of 14.3% implies NZ$0.14 returned on every NZ$1 invested. 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

Returns are usually compared to costs to measure the efficiency of capital. Oceania Healthcare’s cost of equity is 9.0%. Given a positive discrepancy of 5.3% between return and cost, this indicates that Oceania Healthcare pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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 the business is with its cost management. Asset turnover reveals how much revenue can be generated from Oceania Healthcare’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 artificially increased through excessive borrowing, we should check Oceania Healthcare’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a low 31.5%, 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. Oceania Healthcare’s above-industry ROE is encouraging, and is also in excess of 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. Although ROE can be a useful metric, it is only a small part of diligent research.