This article is intended for those of you who are at the beginning of your investing journey and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.

AksharChem (India) Limited (NSE:AKSCHEM) delivered a less impressive 13.0% ROE over the past year, compared to the 13.1% return generated by its industry. Though AKSCHEM’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 AKSCHEM’s below-average returns. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of AKSCHEM’s returns.

See our latest analysis for AksharChem (India)

What you must know about ROE

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 ₹0.13 in earnings from this. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.

Return on Equity = Net Profit ÷ Shareholders Equity

ROE is assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for AksharChem (India), which is 13.5%. This means AksharChem (India)’s returns actually do not cover its own cost of equity, with a discrepancy of -0.5%. This isn’t sustainable as it implies, very simply, that the company pays more 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

Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue AksharChem (India) 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 AksharChem (India)’s historic debt-to-equity ratio. Currently, AksharChem (India) has no debt which means its returns are driven purely by equity capital. This could explain why AksharChem (India)’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.