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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. By way of learning-by-doing, we'll look at ROE to gain a better understanding of Exchange Income Corporation (TSE:EIF).
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
Check out our latest analysis for Exchange Income
How Is ROE Calculated?
The formula for return on equity is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Exchange Income is:
9.6% = CA$122m ÷ CA$1.3b (Based on the trailing twelve months to September 2024).
The 'return' is the income the business earned over the last year. That means that for every CA$1 worth of shareholders' equity, the company generated CA$0.10 in profit.
Does Exchange Income 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. 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, Exchange Income has a lower ROE than the average (17%) in the Airlines industry.
That's not what we like to see. Although, we think that a lower ROE could still mean that a company has the opportunity to better its returns with the use of leverage, provided its existing debt levels are low. A high debt company having a low ROE is a different story altogether and a risky investment in our books. To know the 3 risks we have identified for Exchange Income visit our risks dashboard for free.
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 issuing shares, retained earnings, 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 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.
Exchange Income's Debt And Its 9.6% ROE
Exchange Income does use a high amount of debt to increase returns. It has a debt to equity ratio of 1.60. The combination of a rather low ROE and significant use of debt is not particularly appealing. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.