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 Navin Fluorine International Limited (NSE:NAVINFLUOR), by way of a worked example.

Over the last twelve months Navin Fluorine International has recorded a ROE of 18%. That means that for every ₹1 worth of shareholders’ equity, it generated ₹0.18 in profit.

See our latest analysis for Navin Fluorine International

How Do You Calculate Return On Equity?

The formula for return on equity is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for Navin Fluorine International:

18% = 1797.78 ÷ ₹9.8b (Based on the trailing twelve months to March 2018.)

It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. It is the capital paid in by shareholders, plus any retained earnings. Shareholders’ equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.

What Does ROE 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 yearly profit. 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 ROE can be used to compare two businesses.

Does Navin Fluorine International Have A Good Return On Equity?

One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. Pleasingly, Navin Fluorine International has a superior ROE than the average (13%) company in the chemicals industry.

That’s clearly a positive. In my book, a high ROE almost always warrants a closer look. For example, I often check if insiders have been buying shares .

The Importance Of Debt To Return On Equity

Virtually all companies need money to invest in the business, to grow 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 use of debt will improve the returns, but will not change the equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.