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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. By way of learning-by-doing, we'll look at ROE to gain a better understanding of Aurizon Holdings Limited (ASX:AZJ).
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
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How Is ROE Calculated?
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 Aurizon Holdings is:
9.4% = AU$402m ÷ AU$4.3b (Based on the trailing twelve months to December 2024).
The 'return' is the yearly profit. Another way to think of that is that for every A$1 worth of equity, the company was able to earn A$0.09 in profit.
Check out our latest analysis for Aurizon Holdings
Does Aurizon Holdings Have A Good ROE?
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. You can see in the graphic below that Aurizon Holdings has an ROE that is fairly close to the average for the Transportation industry (9.3%).
That's neither particularly good, nor bad. Even if the ROE is respectable when compared to the industry, its worth checking if the firm's ROE is being aided by high debt levels. If a company takes on too much debt, it is at higher risk of defaulting on interest payments. You can see the 2 risks we have identified for Aurizon Holdings by visiting our risks dashboard for free on our platform here.
The Importance Of Debt To Return On Equity
Most companies need money -- from somewhere -- 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 use of debt will improve the returns, but will not change the equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Aurizon Holdings' Debt And Its 9.4% ROE
It's worth noting the high use of debt by Aurizon Holdings, leading to its debt to equity ratio of 1.23. With a fairly low ROE, and significant use of debt, it's hard to get excited about this business at the moment. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.