Himadri Speciality Chemical Limited (NSEI:HSCL) generated a below-average return on equity of 8.64% in the past 12 months, while its industry returned 14.28%. HSCL’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 HSCL’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of HSCL’s returns. Let me show you what I mean by this. View our latest analysis for Himadri Speciality Chemical
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. An ROE of 8.64% implies ₹0.09 returned on every ₹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. Himadri Speciality Chemical’s cost of equity is 13.40%. Since Himadri Speciality Chemical’s return does not cover its cost, with a difference of -4.76%, this means its current use of equity is not efficient and not sustainable. Very simply, Himadri Speciality Chemical 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. Asset turnover reveals how much revenue can be generated from Himadri Speciality Chemical’s 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 Himadri Speciality Chemical’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a sensible 75.13%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.
Next Steps:
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. Himadri Speciality Chemical 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 Himadri Speciality Chemical’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.