One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. To keep the lesson grounded in practicality, we’ll use ROE to better understand Nelco Limited (NSE:NELCO).

Our data shows Nelco has a return on equity of 45% for the last year. Another way to think of that is that for every ₹1 worth of equity in the company, it was able to earn ₹0.45.

See our latest analysis for Nelco

How Do You Calculate ROE?

The formula for ROE is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for Nelco:

45% = ₹213m ÷ ₹476m (Based on the trailing twelve months to September 2018.)

It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. It is all earnings retained by the company, plus any capital paid in by shareholders. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.

What Does Return On Equity Mean?

ROE measures a company’s profitability against the profit it retains, and any outside investments. The ‘return’ is the yearly profit. A higher profit will lead to a higher ROE. So, as a general rule, a high ROE is a good thing. Clearly, then, one can use ROE to compare different companies.

Does Nelco Have A Good ROE?

Arguably the easiest way to assess company’s ROE is to compare it with the average in its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As you can see in the graphic below, Nelco has a higher ROE than the average (13%) in the communications industry.

That’s what I like to see. In my book, a high ROE almost always warrants a closer look. For example you might check if insiders are buying shares.

How Does Debt Impact ROE?

Virtually all companies need money to invest in the business, to grow profits. That cash can come from issuing 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 use of debt will improve the returns, but will not change the equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.

Nelco’s Debt And Its 45% ROE

Nelco clearly uses a significant amount debt to boost returns, as it has a debt to equity ratio of 1.13. While the ROE is impressive, that metric has clearly benefited from the company’s use of debt. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.