Adairs Limited (ASX:ADH) delivered an ROE of 21.46% over the past 12 months, which is an impressive feat relative to its industry average of 13.11% during the same period. While the impressive ratio tells us that ADH has made significant profits from little equity capital, ROE doesn’t tell us if ADH has borrowed debt to make this happen. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of ADH’s ROE. View our latest analysis for Adairs

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. For example, if ADH invests $1 in the form of equity, it will generate $0.21 in earnings from this. 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 ADH’s equity capital deployed. Its cost of equity is 8.55%. Since ADH’s return covers its cost in excess of 12.90%, its use of equity capital is efficient and likely to be sustainable. Simply put, ADH 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

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 ADH’s asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable ADH’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt ADH currently has. The debt-to-equity ratio currently stands at a low 41.78%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.

What this means for you:

Are you a shareholder? ADH’s ROE is impressive relative to the industry average and also covers its cost of equity. Since its high ROE is not likely driven by high debt, it might be a good time to top up on your current holdings if your fundamental research reaffirms this analysis.

Are you a potential investor? If ADH has been on your watch list for a while, making an investment decision based on ROE alone is unwise. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Adairs to help you make a more informed investment decision. If you are not interested in ADH anymore, you can use our free platform to see our list of stocks with Return on Equity over 20%.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.