Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). We'll use ROE to examine Savannah Energy PLC (LON:SAVE), by way of a worked example.

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

View our latest analysis for Savannah Energy

How To Calculate Return On Equity?

The formula for return on equity is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Savannah Energy is:

5.6% = US$17m ÷ US$307m (Based on the trailing twelve months to December 2021).

The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every £1 worth of equity, the company was able to earn £0.06 in profit.

Does Savannah Energy 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. If you look at the image below, you can see Savannah Energy has a lower ROE than the average (15%) in the Oil and Gas industry classification.

Unfortunately, that's sub-optimal. However, a low ROE is not always bad. If the company's debt levels are moderate to low, then there's still a chance that returns can be improved via the use of financial leverage. When a company has low ROE but high debt levels, we would be cautious as the risk involved is too high. To know the 4 risks we have identified for Savannah Energy visit our risks dashboard for free.

The Importance Of Debt To Return On Equity

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 case of the first and second options, the ROE will reflect this use of cash, for growth. 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.

Savannah Energy's Debt And Its 5.6% ROE

Savannah Energy does use a high amount of debt to increase returns. It has a debt to equity ratio of 1.71. Its ROE is quite low, even with the use of significant debt; that's not a good result, in our opinion. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.