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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 Chorus Limited (NZSE:CNU), by way of a worked example.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Put another way, it reveals the company's success at turning shareholder investments into profits.
See our latest analysis for Chorus
How Do You Calculate Return On Equity?
ROE can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Chorus is:
2.3% = NZ$21m ÷ NZ$919m (Based on the trailing twelve months to December 2023).
The 'return' is the income the business earned over the last year. One way to conceptualize this is that for each NZ$1 of shareholders' capital it has, the company made NZ$0.02 in profit.
Does Chorus Have A Good ROE?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. As is clear from the image below, Chorus has a lower ROE than the average (4.8%) in the Telecom industry.
That's not what we like to see. However, a low ROE is not always bad. If the company's debt levels are moderate to low, then there's still a chance that returns can be improved via the use of financial leverage. When a company has low ROE but high debt levels, we would be cautious as the risk involved is too high. To know the 4 risks we have identified for Chorus visit our risks dashboard for free.
How Does Debt Impact Return On Equity?
Companies usually need to invest money to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the debt required for growth will boost returns, but will not impact the shareholders' equity. That will make the ROE look better than if no debt was used.
Combining Chorus' Debt And Its 2.3% Return On Equity
It seems that Chorus uses a huge volume of debt to fund the business, since it has an extremely high debt to equity ratio of 3.70. Most investors would need a low share price to be interested in a company with low ROE and high debt to equity.