With an ROE of 19.47%, SmartPay Holdings Limited (NZSE:SPY) outpaced its own industry which delivered a less exciting 14.80% over the past year. On the surface, this looks fantastic since we know that SPY has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of SPY’s ROE. See our latest analysis for SmartPay Holdings

What you must know about ROE

Return on Equity (ROE) weighs SmartPay Holdings’s profit against the level of its shareholders’ equity. An ROE of 19.47% implies NZ$0.19 returned on every NZ$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 SmartPay Holdings’s equity capital deployed. Its cost of equity is 12.58%. Since SmartPay Holdings’s return covers its cost in excess of 6.88%, its use of equity capital is efficient and likely to be sustainable. Simply put, SmartPay Holdings 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. The other component, asset turnover, illustrates how much revenue SmartPay Holdings can make from its 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 the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine SmartPay Holdings’s debt-to-equity level. Currently the debt-to-equity ratio stands at a high 178.02%, which means its above-average ROE is driven by significant debt levels.

What this means for you:

Are you a shareholder? SPY’s ROE is impressive relative to the industry average and also covers its cost of equity. However, its high debt level appears to be the driver of a strong ROE and is something you should be mindful of before adding more of SPY to your portfolio. 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%.