This analysis is intended to introduce important early concepts to people who are starting to invest and looking to gauge the potential return on investment in VST Tillers Tractors Limited (NSE:VSTTILLERS).
VST Tillers Tractors Limited (NSE:VSTTILLERS) delivered an ROE of 18.78% over the past 12 months, which is an impressive feat relative to its industry average of 10.80% during the same period. On the surface, this looks fantastic since we know that VSTTILLERS 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 VSTTILLERS’s ROE. See our latest analysis for V.S.T. Tillers Tractors
Breaking down ROE — the mother of all ratios
Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests ₹1 in the form of equity, it will generate ₹0.19 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. V.S.T. Tillers Tractors’s cost of equity is 13.55%. Since V.S.T. Tillers Tractors’s return covers its cost in excess of 5.23%, its use of equity capital is efficient and likely to be sustainable. Simply put, V.S.T. Tillers Tractors pays less for its capital than what it generates in return. 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. The other component, asset turnover, illustrates how much revenue V.S.T. Tillers Tractors 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 artificially increased through excessive borrowing, we should check V.S.T. Tillers Tractors’s historic debt-to-equity ratio. Currently, V.S.T. Tillers Tractors 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.