This article is intended for those of you who are at the beginning of your investing journey and want a simplistic look at the return on Sreeleathers Limited (NSE:SREEL) stock.

Sreeleathers Limited (NSE:SREEL) outperformed the Distributors industry on the basis of its ROE – producing a higher 8.38% relative to the peer average of 1.23% over the past 12 months. Superficially, this looks great since we know that SREEL has generated big profits with little equity capital; however, ROE doesn’t tell us how much SREEL has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of SREEL’s ROE. View out our latest analysis for Sreeleathers

What you must know about ROE

Return on Equity (ROE) is a measure of Sreeleathers’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. 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

Returns are usually compared to costs to measure the efficiency of capital. Sreeleathers’s cost of equity is 13.55%. Since Sreeleathers’s return does not cover its cost, with a difference of -5.17%, this means its current use of equity is not efficient and not sustainable. Very simply, Sreeleathers pays more 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

The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue Sreeleathers can generate with its current 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 artificially increased through excessive borrowing, we should check Sreeleathers’s historic debt-to-equity ratio. Currently Sreeleathers has virtually no debt, which means its returns are predominantly driven by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.

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. Sreeleathers’s above-industry ROE is noteworthy, but it was not high enough to cover its own 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.

For Sreeleathers, I’ve compiled three pertinent aspects you should further research:

1. Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.

2. Valuation: What is Sreeleathers worth today? Is the stock undervalued, even when its growth outlook is factored into its intrinsic value? The intrinsic value infographic in our free research report helps visualize whether Sreeleathers is currently mispriced by the market.

3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Sreeleathers? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.