The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to better understand how you can grow your money by investing in Straco Corporation Limited (SGX:S85).

With an ROE of 15.65%, Straco Corporation Limited (SGX:S85) outpaced its own industry which delivered a less exciting 6.95% over the past year. On the surface, this looks fantastic since we know that S85 has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of S85’s ROE. Check out our latest analysis for Straco

Breaking down Return on Equity

Return on Equity (ROE) weighs Straco’s profit against the level of its shareholders’ equity. An ROE of 15.65% implies SGD0.16 returned on every SGD1 invested. 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. Straco’s cost of equity is 8.94%. Given a positive discrepancy of 6.72% between return and cost, this indicates that Straco pays less for its capital than what it generates in return, which is a sign of capital efficiency. 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

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 Straco can generate with its current 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 Straco’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 16.44%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Straco’s ROE is impressive relative to the industry average and also covers its 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.