Aspial Corporation Limited (SGX:A30) generated a below-average return on equity of 1.37% in the past 12 months, while its industry returned 7.01%. A30’s results could indicate a relatively inefficient operation to its peers, and while this may be the case, it is important to understand what ROE is made up of and how it should be interpreted. Knowing these components could change your view on A30’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of A30’s returns. Let me show you what I mean by this. View our latest analysis for Aspial

Breaking down ROE — the mother of all ratios

Return on Equity (ROE) weighs Aspial’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. 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

ROE is measured against cost of equity in order to determine the efficiency of Aspial’s equity capital deployed. Its cost of equity is 18.12%. Given a discrepancy of -16.75% between return and cost, this indicated that Aspial 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

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 Aspial can generate with its current 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 artificially increased through excessive borrowing, we should check Aspial’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at over 2.5 times, meaning the below-average ratio is already being driven by a large amount of debt.

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Aspial exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Aspial’s return with a possible increase should the company decide to increase its debt levels. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.