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Toyota Caetano Portugal SA. (ENXTLS:SCT) delivered a less impressive 7.14% ROE over the past year, compared to the 15.01% return generated by its industry. SCT’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 SCT’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of SCT’s returns. View our latest analysis for Toyota Caetano Portugal
Breaking down Return on Equity
Return on Equity (ROE) weighs Toyota Caetano Portugal’s profit against the level of its shareholders’ equity. An ROE of 7.14% implies €0.07 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
ROE is measured against cost of equity in order to determine the efficiency of Toyota Caetano Portugal’s equity capital deployed. Its cost of equity is 10.58%. This means Toyota Caetano Portugal’s returns actually do not cover its own cost of equity, with a discrepancy of -3.44%. 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
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 Toyota Caetano Portugal 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 inflated by excessive debt, we need to examine Toyota Caetano Portugal’s debt-to-equity level. The debt-to-equity ratio currently stands at a sensible 60.51%, meaning the ROE is a result of its capacity to produce profit growth without a huge debt burden.