First Business Financial Services Inc (NASDAQ:FBIZ) generated a below-average return on equity of 7.03% in the past 12 months, while its industry returned 8.21%. FBIZ’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 FBIZ’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of FBIZ’s returns. View our latest analysis for First Business Financial Services

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

Return on Equity (ROE) weighs First Business Financial Services’s profit against the level of its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.07 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. First Business Financial Services’s cost of equity is 9.75%. This means First Business Financial Services’s returns actually do not cover its own cost of equity, with a discrepancy of -2.71%. 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

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 First Business Financial Services can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be artificially increased through excessive borrowing, we should check First Business Financial Services’s historic debt-to-equity ratio. At 128.73%, First Business Financial Services’s debt-to-equity ratio appears balanced and indicates its ROE is generated from its capacity to increase profit without a large debt burden.