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 Cortina Holdings Limited (SGX:C41).

Over the last twelve months Cortina Holdings has recorded a ROE of 17%. One way to conceptualize this, is that for each SGD1 of shareholders' equity it has, the company made SGD0.17 in profit.

Check out our latest analysis for Cortina Holdings

How Do I Calculate Return On Equity?

The formula for ROE is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

Or for Cortina Holdings:

17% = S$38m ÷ S$219m (Based on the trailing twelve months to September 2019.)

Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is all the money paid into the company from shareholders, plus any earnings retained. Shareholders' equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.

What Does ROE Mean?

Return on Equity measures a company's profitability against the profit it has kept for the business (plus any capital injections). The 'return' is the yearly profit. That means that the higher the ROE, the more profitable the company is. So, all else equal, investors should like a high ROE. Clearly, then, one can use ROE to compare different companies.

Does Cortina Holdings Have A Good ROE?

By comparing a company's ROE with its industry average, we can get a quick measure of how good it is. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As you can see in the graphic below, Cortina Holdings has a higher ROE than the average (9.6%) in the Specialty Retail industry.

That's clearly a positive. 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?

Most companies need money -- from somewhere -- to grow their profits. That cash can come from retained earnings, issuing new shares (equity), 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.