WuXi Biologics (Cayman) Inc’s (SEHK:2269) most recent return on equity was a substandard 3.90% relative to its industry performance of 9.46% over the past year. Though 2269’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 2269’s below-average returns. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 2269’s returns. Let me show you what I mean by this. View our latest analysis for WuXi Biologics (Cayman)

What you must know about ROE

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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 assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for WuXi Biologics (Cayman), which is 8.85%. Since WuXi Biologics (Cayman)’s return does not cover its cost, with a difference of -4.95%, this means its current use of equity is not efficient and not sustainable. Very simply, WuXi Biologics (Cayman) 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

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 WuXi Biologics (Cayman) can make from its 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 WuXi Biologics (Cayman)’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 32.49%, meaning WuXi Biologics (Cayman) still has headroom to borrow debt to increase profits.