This analysis is intended to introduce important early concepts to people who are starting to invest and want to start learning about core concepts of fundamental analysis on practical examples from today’s market.

The National Security Group Inc (NASDAQ:NSEC) delivered a less impressive 2.2% ROE over the past year, compared to the 8.4% return generated by its industry. NSEC’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 NSEC’s performance. Today I will look at how components such as financial leverage can influence ROE which may impact the sustainability of NSEC’s returns.

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Breaking down Return on Equity

Return on Equity (ROE) weighs National Security Group’s profit against the level of its shareholders’ equity. For example, if the company invests $1 in the form of equity, it will generate $0.022 in earnings from this. 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 National Security Group’s equity capital deployed. Its cost of equity is 10.4%. Given a discrepancy of -8.1% between return and cost, this indicated that National Security Group may be paying more for its capital than what it’s generating 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:

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

The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. The other component, asset turnover, illustrates how much revenue National Security Group can make from its asset base. Finally, financial leverage will be our main focus today. It shows how much of assets are funded by equity and can show how sustainable the company’s capital structure is. Since ROE can be inflated by excessive debt, we need to examine National Security Group’s debt-to-equity level. At 33.4%, National Security Group’s debt-to-equity ratio appears low and indicates that National Security Group still has room to increase leverage and grow its profits.