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 GSS Infotech Limited (NSE:GSS), by way of a worked example.

Our data shows GSS Infotech has a return on equity of 11% for the last year. Another way to think of that is that for every ₹1 worth of equity in the company, it was able to earn ₹0.11.

View our latest analysis for GSS Infotech

How Do I Calculate ROE?

The formula for ROE is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for GSS Infotech:

11% = 143.16626 ÷ ₹1.3b (Based on the trailing twelve months to September 2018.)

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. Shareholders’ equity can be calculated by subtracting the total liabilities of the company from the total assets of the company.

What Does Return On Equity Signify?

ROE measures a company’s profitability against the profit it retains, and any outside investments. The ‘return’ is the yearly profit. The higher the ROE, the more profit the company is making. So, all else equal, investors should like a high ROE. That means ROE can be used to compare two businesses.

Does GSS Infotech Have A Good ROE?

By comparing a company’s ROE with its industry average, we can get a quick measure of how good it is. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. The image below shows that GSS Infotech has an ROE that is roughly in line with the it industry average (11%).

That isn’t amazing, but it is respectable. Generally it will take a while for decisions made by leadership to impact the ROE. So it makes sense to check how long the board and CEO have been in place.

How Does Debt Impact Return On Equity?

Companies usually need to invest money to grow their 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 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.

Combining GSS Infotech’s Debt And Its 11% Return On Equity

One positive for shareholders is that GSS Infotech does not have any net debt! Even though I don’t think its ROE is that great, I think it’s very respectable when you consider it has no debt. After all, when a company has a strong balance sheet, it can often find ways to invest in growth, even if it takes some time.

But It’s Just One Metric

Return on equity is one way we can compare the business quality of different companies. In my book the highest quality companies have high return on equity, despite low debt. If two companies have the same ROE, then I would generally prefer the one with less debt.

Having said that, while ROE is a useful indicator of business quality, you’ll have to look at a whole range of factors to determine the right price to buy a stock. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So I think it may be worth checking this free this detailed graph of past earnings, revenue and cash flow .

Of course GSS Infotech may not be the best stock to buy. So you may wish to see this free collection of other companies that have high ROE and low debt.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.