Finzsoft Solutions Limited (NZSE:FIN) generated a below-average return on equity of 2.33% in the past 12 months, while its industry returned 12.42%. FIN’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 FIN’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of FIN’s returns. Check out our latest analysis for Finzsoft Solutions
What you must know about ROE
Return on Equity (ROE) weighs Finzsoft Solutions’s profit against the level of its shareholders’ equity. An ROE of 2.33% implies NZ$0.02 returned on every NZ$1 invested, so the higher the return, the better. Investors seeking to maximise their return in the Application Software industry may want to choose the highest returning stock. However, this can be misleading as each firm has different costs of equity and debt levels i.e. the more debt Finzsoft Solutions has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden.
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 Finzsoft Solutions, which is 10.01%. Given a discrepancy of -7.68% between return and cost, this indicated that Finzsoft Solutions may be paying more for its capital than what it’s generating in return. ROE can be split up into three useful ratios: net profit margin, asset turnover, and financial leverage. This is called the 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. The other component, asset turnover, illustrates how much revenue Finzsoft Solutions can make from its 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. ROE can be inflated by disproportionately high levels of debt. This is also unsustainable due to the high interest cost that the company will also incur. Thus, we should look at Finzsoft Solutions’s debt-to-equity ratio to examine sustainability of its returns. Currently, Finzsoft Solutions has no debt which means its returns are driven purely by equity capital. This could explain why Finzsoft Solutions’s’ ROE is lower than its industry peers, most of which may have some degree of debt in its business.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Finzsoft Solutions exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. However, ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of returns, which has headroom to increase further. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Finzsoft Solutions, I’ve compiled three important aspects you should look at:
- 1. Financial Health: Does it have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- 2. Future Earnings: How does Finzsoft Solutions’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
- 3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Finzsoft Solutions? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!