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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. By way of learning-by-doing, we'll look at ROE to gain a better understanding of Metals Exploration plc (LON:MTL).
ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. Put another way, it reveals the company's success at turning shareholder investments into profits.
See our latest analysis for Metals Exploration
How Is ROE Calculated?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Metals Exploration is:
57% = US$6.1m ÷ US$11m (Based on the trailing twelve months to June 2022).
The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each £1 of shareholders' capital it has, the company made £0.57 in profit.
Does Metals Exploration Have A Good Return On Equity?
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, Metals Exploration has a higher ROE than the average (16%) in the Metals and Mining industry.
That's clearly a positive. Bear in mind, a high ROE doesn't always mean superior financial performance. A higher proportion of debt in a company's capital structure may also result in a high ROE, where the high debt levels could be a huge risk . You can see the 3 risks we have identified for Metals Exploration by visiting our risks dashboard for free on our platform here.
The Importance Of Debt To Return On Equity
Virtually all companies need money to invest in the business, to grow profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. 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. That will make the ROE look better than if no debt was used.
Metals Exploration's Debt And Its 57% ROE
We think Metals Exploration uses a significant amount of debt to maximize its returns, as it has a significantly higher debt to equity ratio of 8.69. So although the company has an impressive ROE, the company might not have been able to achieve this without the significant use of debt.