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. To keep the lesson grounded in practicality, we’ll use ROE to better understand Jet Knitwears Limited (NSE:JETKNIT).
Over the last twelve months Jet Knitwears has recorded a ROE of 8.0%. Another way to think of that is that for every ₹1 worth of equity in the company, it was able to earn ₹0.080.
View our latest analysis for Jet Knitwears
How Do I Calculate ROE?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders’ Equity
Or for Jet Knitwears:
8.0% = 12.002142 ÷ ₹149m (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 all earnings retained by the company, plus any capital paid in by shareholders. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.
What Does ROE Mean?
ROE measures a company’s profitability against the profit it retains, and any outside investments. The ‘return’ is the profit over the last twelve months. A higher profit will lead to a higher ROE. So, as a general rule, a high ROE is a good thing. Clearly, then, one can use ROE to compare different companies.
Does Jet Knitwears 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. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. If you look at the image below, you can see Jet Knitwears has a similar ROE to the average in the luxury industry classification (7.9%).
That’s not overly surprising. ROE can change from year to year, based on decisions that have been made in the past. So savvy investors often note how long the CEO has been in that position.
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 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.