HMS Networks AB (publ) (OM:HMS) delivered an ROE of 19.79% over the past 12 months, which is an impressive feat relative to its industry average of 14.59% during the same period. On the surface, this looks fantastic since we know that HMS has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether HMS’s ROE is actually sustainable. Check out our latest analysis for HMS Networks

What you must know about ROE

Return on Equity (ROE) weighs HMS Networks’s profit against the level of its shareholders’ equity. An ROE of 19.79% implies SEK0.2 returned on every SEK1 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 HMS Networks’s equity capital deployed. Its cost of equity is 9.46%. Given a positive discrepancy of 10.33% between return and cost, this indicates that HMS Networks pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be split up into three useful 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 HMS Networks’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 HMS Networks’s historic debt-to-equity ratio. Currently the debt-to-equity ratio stands at a reasonable 54.70%, which means its above-average ROE is driven by its ability to grow its profit without a significant debt burden.

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. HMS Networks’s ROE is impressive relative to the industry average and also covers its cost of equity. Its high ROE is not likely to be driven by high debt. Therefore, investors may have more confidence in the sustainability of this level of returns going forward. Although ROE can be a useful metric, it is only a small part of diligent research.