In This Article:
Sulzer Ltd’s (SWX:SUN) most recent return on equity was a substandard 5.12% relative to its industry performance of 13.77% over the past year. Though SUN’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 SUN’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of SUN’s returns. Check out our latest analysis for Sulzer
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) weighs Sulzer’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
Returns are usually compared to costs to measure the efficiency of capital. Sulzer’s cost of equity is 8.49%. Given a discrepancy of -3.37% between return and cost, this indicated that Sulzer 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
Essentially, profit margin shows how much money the company makes after paying for all its expenses. Asset turnover shows how much revenue Sulzer 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 financial leverage can artificially inflate ROE, we need to look at how much debt Sulzer currently has. Currently the debt-to-equity ratio stands at a low 41.93%, which means Sulzer 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. Sulzer’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Sulzer’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.