With an ROE of 8.01%, Sky Solar Holdings Ltd (NASDAQ:SKYS) outpaced its own industry which delivered a less exciting 2.13% over the past year. On the surface, this looks fantastic since we know that SKYS has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. We’ll take a closer look today at factors like financial leverage to determine whether SKYS’s ROE is actually sustainable. See our latest analysis for SKYS
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of SKYS’s profit relative to its shareholders’ equity. An ROE of 8.01% implies $0.08 returned on every $1 invested. While a higher ROE is preferred in most cases, there are several other factors we should consider before drawing any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of SKYS’s equity capital deployed. Its cost of equity is 15.61%. This means SKYS’s returns actually do not cover its own cost of equity, with a discrepancy of -7.61%. This isn’t sustainable as it implies, very simply, that the company pays more for its capital than what it generates 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
Basically, profit margin measures how much of revenue trickles down into earnings which illustrates how efficient SKYS is with its cost management. Asset turnover shows how much revenue SKYS can generate with its current asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable SKYS’s capital structure is. Since financial leverage can artificially inflate ROE, we need to look at how much debt SKYS currently has. The debt-to-equity ratio currently stands at a high 163.86%, meaning the above-average ratio is a result of a large amount of debt.
What this means for you:
Are you a shareholder? SKYS exhibits a strong ROE against its peers, however it was not high enough to cover its own cost of equity this year. Additionally, its high debt level appears to be the driver of a strong ROE and is something you should be mindful of before adding more of SKYS to your portfolio. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.
Are you a potential investor? If you are considering investing in SKYS, basing your decision on ROE alone is certainly not sufficient. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Sky Solar Holdings to help you make a more informed investment decision.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.