While some investors are already familiar with financial metrics (hat tip), this article is for those who want to learn more about return on equity (ROE) and why it is important. We will use ROE to examine Embellence Group AB (publ) (STO: EMBELL), using a real-world example.
Return on equity or ROE is a key metric used to assess the efficiency with which the management of a business is using business capital. In other words, it is a profitability ratio that measures the rate of return on capital contributed by the shareholders of the company.
See our latest analysis for Embellence Group
How is the ROE calculated?
The return on equity formula is:
Return on equity = Net income (from continuing operations) ÷ Equity
Thus, based on the above formula, the ROE for Embellence Group is:
20% = kr55m kr271m (based on the last twelve months up to September 2021).
“Return” refers to a company’s profits over the past year. Another way to look at this is that for every SEK1 value of equity, the company was able to earn SEK0.20 in profit.
Does Embellence Group have a good return on equity?
A simple way to determine if a company has a good return on equity is to compare it to the average in its industry. However, this method is only useful as a rough check, as companies differ a little within the same industry classification. As shown in the image below, Embellence Group has a better ROE than the average (15%) in the durable consumer goods industry.
This is clearly a positive point. Keep in mind that a high ROE doesn’t always mean superior financial performance. A higher proportion of debt in a company’s capital structure can also result in high ROE, where high debt levels could represent a huge risk. You can see the 3 risks we have identified for Embellence Group by visiting our risk dashboard for free on our platform here.
What is the impact of debt on ROE?
Businesses generally need to invest money to increase their profits. This liquidity can come from the issuance of shares, retained earnings or debt. In the first and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the debt used for growth will improve returns, but will not affect total equity. So, using debt can improve ROE, but with added risk in stormy weather, metaphorically speaking.
The debt of the Embellence group and its ROE of 20%
Embellence Group has a debt ratio of 0.56, which is far from excessive. The combination of modest debt and a very impressive ROE suggests that the business is high quality. Using debt wisely to improve returns can certainly be a good thing, even if it slightly increases risk and lowers future option.
Return on equity is a useful indicator of a company’s ability to generate profits and return them to shareholders. Firms that can earn high returns on equity without taking on too much debt are generally of good quality. If two companies have the same ROE, then I would generally prefer the one with the least amount of debt.
That said, while ROE is a useful indicator of how good a business is, you’ll need to look at a whole range of factors to determine the right price to buy a stock. The rate at which earnings are likely to grow, relative to earnings growth expectations reflected in the current price, should also be considered. You can see how the business has grown in the past by checking out this FREE detailed graphic past earnings, income and cash flow.
If you would rather consult with another company – one with potentially superior finances – then don’t miss this free list of interesting companies, which have a HIGH return on equity and low leverage.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in the mentioned stocks.
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