Farmers Capital Bank Corporation (NASDAQ:FFKT) generated a below-average return on equity of 6.05% in the past 12 months, while its industry returned 8.20%. Though FFKT’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 FFKT’s below-average returns. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of FFKT’s returns. View our latest analysis for Farmers Capital Bank

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. For example, if the company invests $1 in the form of equity, it will generate $0.06 in earnings from this. In most cases, a higher ROE is preferred; however, there are many other factors we must consider prior to making any investment decisions.

Return on Equity = Net Profit ÷ Shareholders Equity

ROE is measured against cost of equity in order to determine the efficiency of Farmers Capital Bank’s equity capital deployed. Its cost of equity is 9.79%. Since Farmers Capital Bank’s return does not cover its cost, with a difference of -3.74%, this means its current use of equity is not efficient and not sustainable. Very simply, Farmers Capital Bank pays more for its capital than what it generates in return. 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

The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover reveals how much revenue can be generated from Farmers Capital Bank’s 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 Farmers Capital Bank’s debt-to-equity level. The debt-to-equity ratio currently stands at a low 36.84%, meaning Farmers Capital Bank still has headroom to borrow debt to increase profits.

Next Steps:

ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Farmers Capital Bank’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.