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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. To keep the lesson grounded in practicality, we'll use ROE to better understand Alicon Castalloy Limited (NSE:ALICON).
Our data shows Alicon Castalloy has a return on equity of 15% 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 ₹0.15.
See our latest analysis for Alicon Castalloy
How Do You Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Alicon Castalloy:
15% = ₹457m ÷ ₹3.1b (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. You can calculate shareholders' equity by subtracting the company's total liabilities from its 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. A higher profit will lead to a higher ROE. So, all else equal, investors should like a high ROE. That means ROE can be used to compare two businesses.
Does Alicon Castalloy 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. 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, Alicon Castalloy has a higher ROE than the average (12%) in the Auto Components industry.
That is a good sign. We think a high ROE, alone, is usually enough to justify further research into a company. One data point to check is if insiders have bought shares recently.
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 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. That will make the ROE look better than if no debt was used.
Combining Alicon Castalloy's Debt And Its 15% Return On Equity
It's worth noting the significant use of debt by Alicon Castalloy, leading to its debt to equity ratio of 1.01. While the ROE isn't too bad, it would probably be a lot lower if the company was forced to reduce debt. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.