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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 Precision Wires India Ltd. (NSE:PRECWIRE), by way of a worked example.
Over the last twelve months Precision Wires India has recorded a ROE of 14%. One way to conceptualize this, is that for each ₹1 of shareholders' equity it has, the company made ₹0.14 in profit.
View our latest analysis for Precision Wires India
How Do You Calculate ROE?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Precision Wires India:
14% = ₹381m ÷ ₹2.7b (Based on the trailing twelve months to June 2019.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is all earnings retained by the company, plus any capital paid in by shareholders. You can calculate shareholders' equity by subtracting the company's total liabilities from its total assets.
What Does ROE Signify?
ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the yearly profit. The higher the ROE, the more profit the company is making. So, all else being equal, a high ROE is better than a low one. That means it can be interesting to compare the ROE of different companies.
Does Precision Wires India Have A Good Return On Equity?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As is clear from the image below, Precision Wires India has a better ROE than the average (8.2%) in the Electrical industry.
That is a good sign. We think a high ROE, alone, is usually enough to justify further research into a company. For example, I often check if insiders have been buying shares .
How Does Debt Impact ROE?
Virtually all companies need money to invest in the business, to grow profits. That cash can come from retained earnings, issuing new shares (equity), or debt. 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. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Combining Precision Wires India's Debt And Its 14% Return On Equity
Although Precision Wires India does use a little debt, its debt to equity ratio of just 0.089 is very low. Although the ROE isn't overly impressive, the debt load is modest, suggesting the business has potential. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.