In This Article:
Sonic Healthcare Limited (ASX:SHL) outperformed the Healthcare Services industry on the basis of its ROE – producing a higher 11.70% relative to the peer average of 11.27% over the past 12 months. On the surface, this looks fantastic since we know that SHL has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable SHL’s ROE is. See our latest analysis for Sonic Healthcare
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) weighs Sonic Healthcare’s profit against the level of its shareholders’ equity. For example, if the company invests A$1 in the form of equity, it will generate A$0.12 in earnings from this. 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 Sonic Healthcare, which is 8.55%. Since Sonic Healthcare’s return covers its cost in excess of 3.15%, its use of equity capital is efficient and likely to be sustainable. Simply put, Sonic Healthcare pays less for its capital than what it generates 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
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 Sonic Healthcare 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 inflated by excessive debt, we need to examine Sonic Healthcare’s debt-to-equity level. The debt-to-equity ratio currently stands at a sensible 70.22%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.