The content of this article will benefit those of you who are starting to educate yourself about investing in the stock market and want to better understand how you can grow your money by investing in Finzsoft Solutions Limited (NZSE:FIN).
Finzsoft Solutions Limited (NZSE:FIN) delivered a less impressive 2.33% ROE over the past year, compared to the 15.79% return generated by its industry. 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. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of FIN’s returns. View out our latest analysis for Finzsoft Solutions
Peeling the layers of ROE – trisecting a company’s profitability
Return on Equity (ROE) is a measure of Finzsoft Solutions’s profit relative to its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Investors seeking to maximise their return in the Application Software industry may want to choose the highest returning stock. But this can be misleading as each company has different costs of equity and also varying debt levels, which could artificially push up ROE whilst accumulating high interest expense.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Finzsoft Solutions’s equity capital deployed. Its cost of equity is 10.39%. Given a discrepancy of -8.06% 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient the business is with its cost management. Asset turnover reveals how much revenue can be generated from Finzsoft Solutions’s 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. We can assess whether Finzsoft Solutions is fuelling ROE by excessively raising debt. Ideally, Finzsoft Solutions should have a balanced capital structure, which we can check by looking at the historic debt-to-equity ratio of the company. 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’s ROE is underwhelming relative to the industry average, and its returns were also not strong enough to cover its own cost of equity. Although, its appropriate level of leverage means investors can be more confident in the sustainability of Finzsoft Solutions’s return with a possible increase should the company decide to increase its debt levels. 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 factors you should further research:
- 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.
- 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.
- 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!