With an ROE of 25.72%, Flexible Solutions International Inc (AMEX:FSI) outpaced its own industry which delivered a less exciting 13.84% over the past year. Superficially, this looks great since we know that FSI has generated big profits with little equity capital; however, ROE doesn’t tell us how much FSI has borrowed in debt. In this article, we’ll closely examine some factors like financial leverage to evaluate the sustainability of FSI’s ROE. See our latest analysis for Flexible Solutions International
What you must know about ROE
Return on Equity (ROE) weighs Flexible Solutions International’s profit against the level of its shareholders’ equity. It essentially shows how much the company can generate in earnings given the amount of equity it has raised. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of Flexible Solutions International’s equity capital deployed. Its cost of equity is 8.50%. Since Flexible Solutions International’s return covers its cost in excess of 17.22%, its use of equity capital is efficient and likely to be sustainable. Simply put, Flexible Solutions International pays less 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 the business is with its cost management. Asset turnover reveals how much revenue can be generated from Flexible Solutions International’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. Since ROE can be artificially increased through excessive borrowing, we should check Flexible Solutions International’s historic debt-to-equity ratio. The debt-to-equity ratio currently stands at a low 3.99%, meaning the above-average ROE is due to its capacity to produce profit growth without a huge debt burden.
ROE is one of many ratios which meaningfully dissects financial statements, which illustrates the quality of a company. Flexible Solutions International’s above-industry ROE is encouraging, and is also in excess of its cost of equity. ROE is not likely to be inflated by excessive debt funding, giving shareholders more conviction in the sustainability of high returns. ROE is a helpful signal, but it is definitely not sufficient on its own to make an investment decision.
For Flexible Solutions International, I’ve compiled three essential aspects you should look at:
1. 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.
2. Future Earnings: How does Flexible Solutions International’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.
3. Other High-Growth Alternatives : Are there other high-growth stocks you could be holding instead of Flexible Solutions International? Explore our interactive list of stocks with large growth potential to get an idea of what else is out there you may be missing!
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.