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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 Ag Growth International Inc. (TSE:AFN), 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. Put another way, it reveals the company's success at turning shareholder investments into profits.
View our latest analysis for Ag Growth International
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 Ag Growth International is:
4.5% = CA$13m ÷ CA$287m (Based on the trailing twelve months to March 2022).
The 'return' is the income the business earned over the last year. Another way to think of that is that for every CA$1 worth of equity, the company was able to earn CA$0.05 in profit.
Does Ag Growth International 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. The image below shows that Ag Growth International has an ROE that is roughly in line with the Machinery industry average (5.7%).
That isn't amazing, but it is respectable. While at least the ROE is not lower than the industry, its still worth checking what role the company's debt plays as high debt levels relative to equity may also make the ROE appear high. If a company takes on too much debt, it is at higher risk of defaulting on interest payments. You can see the 3 risks we have identified for Ag Growth International by visiting our risks dashboard for free on our platform here.
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 two cases, the ROE will capture this use of capital to grow. 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.
Ag Growth International's Debt And Its 4.5% ROE
It seems that Ag Growth International uses a huge volume of debt to fund the business, since it has an extremely high debt to equity ratio of 3.37. We consider it to be a negative sign when a company has a rather low ROE despite a rather high debt to equity.