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 Sobha Limited (NSE:SOBHA).

Our data shows Sobha has a return on equity of 14% for the last year. One way to conceptualize this, is that for each ₹1 of shareholders' equity it has, the company made ₹0.14 in profit.

See our latest analysis for Sobha

How Do I Calculate Return On Equity?

The formula for ROE is:

Return on Equity = Net Profit ÷ Shareholders' Equity

Or for Sobha:

14% = ₹3.3b ÷ ₹23b (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 the capital paid in by shareholders, plus any retained earnings. The easiest way to calculate shareholders' equity is to subtract the company's total liabilities from the total assets.

What Does ROE Signify?

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. That means that the higher the ROE, the more profitable the company is. So, as a general rule, a high ROE is a good thing. That means ROE can be used to compare two businesses.

Does Sobha 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. As you can see in the graphic below, Sobha has a higher ROE than the average (3.9%) in the Real Estate industry.

That's what I like to see. In my book, a high ROE almost always warrants a closer look. For example, I often check if insiders have been buying shares .

How Does Debt Impact ROE?

Most companies need money -- from somewhere -- 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 use of debt will improve the returns, but will not change the equity. That will make the ROE look better than if no debt was used.

Combining Sobha's Debt And Its 14% Return On Equity

Sobha does use a significant amount of debt to increase returns. It has a debt to equity ratio of 1.14. Its ROE isn't too bad, but it would probably be very disappointing if the company had to stop using debt. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.