This analysis is intended to introduce important early concepts to people who are starting to invest and want to better understand how you can grow your money by investing in Finzsoft Solutions Limited (NZSE:FIN).
Finzsoft Solutions Limited’s (NZSE:FIN) most recent return on equity was a substandard 2.33% relative to its industry performance of 15.79% over the past year. 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
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 NZ$1 in the form of equity, it will generate NZ$0.023 in earnings from this. 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 10.40%. Given a discrepancy of -8.07% 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 dissected into three distinct 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
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 Finzsoft Solutions 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. We can determine if Finzsoft Solutions’s ROE is inflated by borrowing high levels of debt. Generally, a balanced capital structure means its returns will be sustainable over the long run. We can examine this by looking at Finzsoft Solutions’s debt-to-equity ratio. 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.
While ROE is a relatively simple calculation, it can be broken down into different ratios, each telling a different story about the strengths and weaknesses 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 essential aspects you should further examine:
- 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!