With an ROE of 6.84%, BO.S Better Online Solutions Ltd. (NASDAQ:BOSC) returned in-line to its own industry which delivered 6.83% over the past year. But what is more interesting is whether BOSC can sustain this level of return. Sustainability can be gauged by a company’s financial leverage – the more debt it has, the higher ROE is pumped up in the short term, at the expense of long term interest payment burden. Let me show you what I mean by this. See our latest analysis for B.O.S Better Online Solutions
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. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. If investors diversify their portfolio by industry, they may want to maximise their return in the Communications Equipment sector by investing in the highest returning stock. However, this can be deceiving as each company has varying costs of equity and debt levels, which could exaggeratedly push up ROE at the same time as accumulating high interest expense.
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 B.O.S Better Online Solutions, which is 12.01%. Since B.O.S Better Online Solutions’s return does not cover its cost, with a difference of -5.17%, this means its current use of equity is not efficient and not sustainable. Very simply, B.O.S Better Online Solutions pays more for its capital than what it generates 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
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 B.O.S Better Online Solutions can make from its asset base. The most interesting ratio, and reflective of sustainability of its ROE, is financial leverage. We can determine if B.O.S Better Online 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 B.O.S Better Online Solutions’s debt-to-equity ratio. The most recent ratio is 30.42%, which is sensible and indicates B.O.S Better Online Solutions has not taken on too much leverage. Thus, we can conclude its above-average ROE is generated from its capacity to increase profit without a large debt burden.
ROE is a simple yet informative ratio, illustrating the various components that each measure the quality of the overall stock. B.O.S Better Online Solutions exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of industry-beating returns. Although ROE can be a useful metric, it is only a small part of diligent research.
For B.O.S Better Online Solutions, I’ve put together three key aspects you should further research:
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