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 Elders Limited (ASX:ELD).

Our data shows Elders has a return on equity of 19% for the last year. One way to conceptualize this, is that for each A$1 of shareholders' equity it has, the company made A$0.19 in profit.

See our latest analysis for Elders

How Do I Calculate ROE?

The formula for ROE is:

Return on Equity = Net Profit ÷ Shareholders' Equity

Or for Elders:

19% = AU$60m ÷ AU$326m (Based on the trailing twelve months to March 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 Return On Equity Signify?

ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the amount earned after tax over the last twelve months. A higher profit will lead to a higher ROE. So, all else equal, investors should like a high ROE. That means it can be interesting to compare the ROE of different companies.

Does Elders 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. 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, Elders has a better ROE than the average (7.2%) in the Food industry.

That's clearly a positive. I usually take a closer look when a company has a better ROE than industry peers. One data point to check is if insiders have bought shares recently.

How Does Debt Impact ROE?

Virtually all companies need money to invest in the business, to grow profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. 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 used for growth will improve returns, but won't affect the total equity. That will make the ROE look better than if no debt was used.

Combining Elders's Debt And Its 19% Return On Equity

While Elders does have some debt, with debt to equity of just 0.63, we wouldn't say debt is excessive. The fact that it achieved a fairly good ROE with only modest debt suggests the business might be worth putting on your watchlist. Careful use of debt to boost returns is often very good for shareholders. However, it could reduce the company's ability to take advantage of future opportunities.