Xiwang Special Steel Company Limited (SEHK:1266) delivered an ROE of 17.45% over the past 12 months, which is an impressive feat relative to its industry average of 9.35% during the same period. On the surface, this looks fantastic since we know that 1266 has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether 1266’s ROE is actually sustainable. See our latest analysis for Xiwang Special Steel

Breaking down ROE — the mother of all ratios

Firstly, Return on Equity, or ROE, is simply the percentage of last years’ earning against the book value of shareholders’ equity. For example, if the company invests HK$1 in the form of equity, it will generate HK$0.17 in earnings from this. 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 assessed against cost of equity, which is measured using the Capital Asset Pricing Model (CAPM) – but let’s not dive into the details of that today. For now, let’s just look at the cost of equity number for Xiwang Special Steel, which is 14.03%. This means Xiwang Special Steel returns enough to cover its own cost of equity, with a buffer of 3.42%. This sustainable practice implies that the company pays less 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

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 Xiwang Special Steel can make from its 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 financial leverage can artificially inflate ROE, we need to look at how much debt Xiwang Special Steel currently has. The debt-to-equity ratio currently stands at a sensible 83.77%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.