Vixtel Technologies Holdings Limited (SEHK:8342) delivered an ROE of 17.77% over the past 12 months, which is an impressive feat relative to its industry average of 12.56% during the same period. Superficially, this looks great since we know that 8342 has generated big profits with little equity capital; however, ROE doesn’t tell us how much 8342 has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of 8342’s ROE. Check out our latest analysis for Vixtel Technologies Holdings

Peeling the layers of ROE – trisecting a company’s profitability

Return on Equity (ROE) is a measure of Vixtel Technologies Holdings’s profit relative to its shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.18 in earnings from this. 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. Vixtel Technologies Holdings’s cost of equity is 9.70%. Since Vixtel Technologies Holdings’s return covers its cost in excess of 8.07%, its use of equity capital is efficient and likely to be sustainable. Simply put, Vixtel Technologies Holdings 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

Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. The other component, asset turnover, illustrates how much revenue Vixtel Technologies Holdings can make from its 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 inflated by excessive debt, we need to examine Vixtel Technologies Holdings’s debt-to-equity level. Currently, Vixtel Technologies Holdings has no debt which means its returns are driven purely 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.