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 Leong Hup International Berhad (KLSE:LHI), by way of a worked example.
ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. Put another way, it reveals the company's success at turning shareholder investments into profits.
Check out our latest analysis for Leong Hup International Berhad
How To Calculate Return On Equity?
Return on equity 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 Leong Hup International Berhad is:
9.4% = RM244m ÷ RM2.6b (Based on the trailing twelve months to December 2022).
The 'return' is the income the business earned over the last year. Another way to think of that is that for every MYR1 worth of equity, the company was able to earn MYR0.09 in profit.
Does Leong Hup International Berhad 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. If you look at the image below, you can see Leong Hup International Berhad has a similar ROE to the average in the Food industry classification (10%).
That's neither particularly good, nor bad. Although the ROE is similar to the industry, we should still perform further checks to see if the company's ROE is being boosted by high debt levels. If a company takes on too much debt, it is at higher risk of defaulting on interest payments.
The Importance Of Debt To Return On Equity
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.
Leong Hup International Berhad's Debt And Its 9.4% ROE
Leong Hup International Berhad clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.16. The combination of a rather low ROE and significant use of debt is not particularly appealing. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.