Xinchen China Power Holdings Limited’s (SEHK:1148) most recent return on equity was a substandard 4.40% relative to its industry performance of 12.75% over the past year. 1148’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 1148’s performance. Metrics such as financial leverage can impact the level of ROE which in turn can affect the sustainability of 1148’s returns. Let me show you what I mean by this. View our latest analysis for Xinchen China Power Holdings

Breaking down Return on Equity

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.

Return on Equity = Net Profit ÷ Shareholders Equity

ROE is measured against cost of equity in order to determine the efficiency of Xinchen China Power Holdings’s equity capital deployed. Its cost of equity is 18.12%. Since Xinchen China Power Holdings’s return does not cover its cost, with a difference of -13.72%, this means its current use of equity is not efficient and not sustainable. Very simply, Xinchen China Power Holdings pays more for its capital than what it generates 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

Essentially, profit margin shows how much money the company makes after paying for all its expenses. The other component, asset turnover, illustrates how much revenue Xinchen China Power Holdings can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. Since ROE can be inflated by excessive debt, we need to examine Xinchen China Power Holdings’s debt-to-equity level. Currently the debt-to-equity ratio stands at a reasonable 59.88%, which means its ROE is driven by its ability to grow its profit without a significant debt burden.

Next Steps:

ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Xinchen China Power Holdings’s below-industry ROE is disappointing, furthermore, its returns were not even high enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Xinchen China Power Holdings’s return with a possible increase should the company decide to increase its debt levels. Although ROE can be a useful metric, it is only a small part of diligent research.