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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. We'll use ROE to examine GenusPlus Group Limited (ASX:GNP), by way of a worked example.
Return on equity or ROE is an important factor to be considered by a shareholder because it tells them how effectively their capital is being reinvested. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
View our latest analysis for GenusPlus Group
How To Calculate Return On Equity?
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 GenusPlus Group is:
23% = AU$13m ÷ AU$58m (Based on the trailing twelve months to June 2021).
The 'return' is the income the business earned over the last year. That means that for every A$1 worth of shareholders' equity, the company generated A$0.23 in profit.
Does GenusPlus Group 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. As is clear from the image below, GenusPlus Group has a better ROE than the average (12%) in the Construction industry.
That's what we like to see. However, bear in mind that a high ROE doesn’t necessarily indicate efficient profit generation. Especially when a firm uses high levels of debt to finance its debt which may boost its ROE but the high leverage puts the company at risk. Our risks dashboardshould have the 2 risks we have identified for GenusPlus Group.
How Does Debt Impact ROE?
Companies usually need to invest money 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 debt required for growth will boost returns, but will not impact the shareholders' equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.
GenusPlus Group's Debt And Its 23% ROE
While GenusPlus Group does have some debt, with a debt to equity ratio of just 0.12, we wouldn't say debt is excessive. Its ROE is very impressive, and given only modest debt, this suggests the business is high quality. 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.