The return on equity (ROE) metric measures a company’s ability to generate a profit with the shareholders’ capital it has. Generally speaking, a high ROE is preferred over a low one, all things being equal.
But, the ROE can actually be broken down into greater detail to provide even more useful insight:
ROE = Profit Margin x Asset Turnover x Equity Multiplier
Some of you may find the formula above familiar. It is actually the DuPont formula, created by the DuPont Corporation nearly a hundred years ago in the 1920s to measure its internal efficiency.
In this piece, let’s use the formula on Courts Asia Ltd (SGX: RE2) for a behind the scenes look at why the company’s ROE has fallen hard over its last five fiscal years. You can see the company’s ROE in the following chart:
Source: Courts Asia’s Annual Report
As a quick background, Courts Asia is a furniture and electronic products retailer with a presence in Singapore, Malaysia, and Indonesia. The company was listed in 2012 at a price of S$0.77. Courts Asia’s stock has not been performing well since its listing, down by over 40% to S$0.425 today.
Let’s break down Courts Asia’s ROE using the DuPont formula. This is shown in the following chart:
Source: Courts Asia’s Annual Report
From the financial year ended 31 March 2012 (FY2012) to FY2016, Courts Asia’s profit margin – the first component of the DuPont formula – had been under pressure, declining from above 5% to just under 3%.
The second component, asset turnover, is a measure of how good Courts Asia is at utilizing its assets to generate revenue. It is calculated by dividing the company’s revenue with its assets. Generally, a higher asset turnover translates to a better performance.
Courts Asia has a declining asset turnover. This is an indication that the company is taking longer to sell its wares and requires more assets to maintain the same amount of revenue. To the former point, a peep into the financials reveal that Courts Asia’s inventory turnover days (a proxy for how long the company’s inventory sits on the shelves before getting sold) has risen from 47 days in FY2012 to 57 in FY2016, according to data from S&P Global Market Intelligence.
The last component of the DuPont formula is the equity multiplier and it is found by dividing a company’s assets with its equity. It is a gauge for how much leverage – and hence financial risk – Courts Asia is taking on.
From the chart above, we can see that the equity multiplier has been rising over the past few years. While higher leverage generally translates to higher ROEs, the effects for Courts Asia have been offset by the company’s deteriorating profit margin and asset turnover.
Not only has Courts Asia’s ROE not improved, its balance sheet has seen more debt pile on. Total debt (including capital leases) has increased by 83%, from S$203 million in FY2012 to S$372.1 million in FY2016.
A Fool’s take
To sum up what the DuPont formula has showed us, Courts Asia’s profit margins are getting thinner, it is taking longer to sell its inventory, and its debt burden is rising.
It should be noted that more work needs to be done beyond the DuPont analysis before any firm investing conclusion can be made on Courts Asia. This deeper look at the company’s ROE should only be seen as a useful starting point for further research.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Wilson Ong doesn’t own shares in any companies mentioned.