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. We'll use ROE to examine G N A Axles Limited (NSE:GNA), by way of a worked example.

Our data shows G N A Axles has a return on equity of 17% for the last year. That means that for every ₹1 worth of shareholders' equity, it generated ₹0.17 in profit.

See our latest analysis for G N A Axles

How Do You Calculate ROE?

The formula for return on equity is:

Return on Equity = Net Profit ÷ Shareholders' Equity

Or for G N A Axles:

17% = ₹700m ÷ ₹4.0b (Based on the trailing twelve months to June 2019.)

Most know that net profit is the total earnings after all expenses, but the concept of shareholders' equity is a little more complicated. 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 Signify?

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 profit over the last twelve months. That means that the higher the ROE, the more profitable the company is. So, all else being equal, a high ROE is better than a low one. That means ROE can be used to compare two businesses.

Does G N A Axles 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. Pleasingly, G N A Axles has a superior ROE than the average (12%) company in the Auto Components industry.

That is a good sign. I usually take a closer look when a company has a better ROE than industry peers. For example you might check if insiders are buying shares.

The Importance Of Debt To Return On Equity

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 case of the first and second options, the ROE will reflect this use of cash, for growth. 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.

G N A Axles's Debt And Its 17% ROE

Although G N A Axles does use debt, its debt to equity ratio of 0.38 is still low. Its very respectable ROE, combined with only modest debt, suggests the business is in good shape. Conservative use of debt to boost returns is usually a good move for shareholders, though it does leave the company more exposed to interest rate rises.