Asta Funding Inc’s (NASDAQ:ASFI) most recent return on equity was a substandard 0.43% relative to its industry performance of 10.73% over the past year. ASFI'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 ASFI’s performance. I will take you through how metrics such as financial leverage impact ROE which may affect the overall sustainability of ASFI's returns. Check out our latest analysis for Asta Funding
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 ASFI can generate in earnings given the amount of equity it has raised. 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 ASFI’s equity capital deployed. Its cost of equity is 8.49%. Since ASFI’s return does not cover its cost, with a difference of -8.06%, this means its current use of equity is not efficient and not sustainable. Very simply, ASFI pays more for its capital than what it generates in return. ROE can be broken down into three different 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 ASFI is with its cost management. Asset turnover shows how much revenue ASFI 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 ASFI’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine ASFI’s debt-to-equity level. At 70.71%, ASFI’s debt-to-equity ratio appears sensible and indicates its ROE is generated from its capacity to increase profit without a large debt burden.
What this means for you:
Are you a shareholder? ASFI exhibits a weak ROE against its peers, as well as insufficient levels to cover its own cost of equity this year. Since its existing ROE is not fuelled by unsustainable debt, investors shouldn’t give up as ASFI still has capacity to improve shareholder returns by borrowing to invest in new projects in the future. 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 ASFI, looking at ROE on its own is not enough to make a well-informed decision. I recommend you do additional fundamental analysis by looking through our most recent infographic report on Asta Funding 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.