Zenitas Healthcare Limited’s (ASX:ZNT) most recent return on equity was a substandard 7.34% relative to its industry performance of 11.27% over the past year. An investor may attribute an inferior ROE to a relatively inefficient performance, and whilst this can often be the case, knowing the nuts and bolts of the ROE calculation may change that perspective and give you a deeper insight into ZNT’s past performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of ZNT’s returns. Let me show you what I mean by this. View our latest analysis for Zenitas Healthcare

Breaking down Return on Equity

Return on Equity (ROE) is a measure of Zenitas Healthcare’s profit relative to its shareholders’ equity. An ROE of 7.34% implies A$0.07 returned on every A$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

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 Zenitas Healthcare, which is 8.55%. Given a discrepancy of -1.21% between return and cost, this indicated that Zenitas Healthcare may be paying more for its capital than what it’s generating in return. ROE can be dissected into three distinct 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 Zenitas Healthcare’s asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since financial leverage can artificially inflate ROE, we need to look at how much debt Zenitas Healthcare currently has. Currently the debt-to-equity ratio stands at a low 27.96%, which means Zenitas Healthcare still has headroom to take on more leverage in order to increase profits.

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. Zenitas Healthcare exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Zenitas Healthcare’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.