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While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. We'll use ROE to examine ADF Foods Limited (NSE:ADFFOODS), by way of a worked example.
Our data shows ADF Foods has a return on equity of 15% for the last year. That means that for every ₹1 worth of shareholders' equity, it generated ₹0.15 in profit.
Check out our latest analysis for ADF Foods
How Do You Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for ADF Foods:
15% = ₹253m ÷ ₹1.7b (Based on the trailing twelve months to March 2019.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is all earnings retained by the company, plus any capital paid in by shareholders. Shareholders' equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.
What Does ROE Mean?
ROE measures a company's profitability against the profit it retains, and any outside investments. The 'return' is the profit over the last twelve months. The higher the ROE, the more profit the company is making. So, as a general rule, a high ROE is a good thing. That means it can be interesting to compare the ROE of different companies.
Does ADF Foods Have A Good Return On Equity?
By comparing a company's ROE with its industry average, we can get a quick measure of how good it is. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. Pleasingly, ADF Foods has a superior ROE than the average (8.1%) company in the Food industry.
That's what I like to see. In my book, a high ROE almost always warrants a closer look. One data point to check is if insiders have bought shares recently.
How Does Debt Impact ROE?
Companies usually need to invest money to grow their 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 debt required for growth will boost returns, but will not impact the shareholders' equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Combining ADF Foods's Debt And Its 15% Return On Equity
ADF Foods is free of net debt, which is a positive for shareholders. Even though I don't think its ROE is that great, I think it's very respectable when you consider it has no debt. At the end of the day, when a company has zero debt, it is in a better position to take future growth opportunities.