Heron Resources Limited (ASX:HRR) delivered a less impressive 5.79% ROE over the past year, compared to the 11.24% return generated by its industry. HRR’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 HRR’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of HRR’s returns. View our latest analysis for Heron Resources

What you must know about ROE

Return on Equity (ROE) weighs Heron Resources’s profit against the level of its shareholders’ equity. An ROE of 5.79% implies A$0.06 returned on every A$1 invested. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.

Return on Equity = Net Profit ÷ Shareholders Equity

Returns are usually compared to costs to measure the efficiency of capital. Heron Resources’s cost of equity is 9.50%. This means Heron Resources’s returns actually do not cover its own cost of equity, with a discrepancy of -3.71%. 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 split up into three useful 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 reveals how much revenue can be generated from Heron Resources’s 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 Heron Resources’s historic debt-to-equity ratio. Currently, Heron Resources has no debt which means its returns are driven purely by equity capital. This could explain why Heron Resources’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.