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One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. By way of learning-by-doing, we'll look at ROE to gain a better understanding of The Keg Royalties Income Fund (TSE:KEG.UN).
ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.
See our latest analysis for Keg Royalties Income Fund
How Do You Calculate Return On Equity?
The formula for ROE is:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Keg Royalties Income Fund is:
4.5% = CA$4.6m ÷ CA$102m (Based on the trailing twelve months to September 2024).
The 'return' is the income the business earned over the last year. Another way to think of that is that for every CA$1 worth of equity, the company was able to earn CA$0.04 in profit.
Does Keg Royalties Income Fund 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. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. If you look at the image below, you can see Keg Royalties Income Fund has a lower ROE than the average (11%) in the Hospitality industry classification.
That's not what we like to see. That being said, a low ROE is not always a bad thing, especially if the company has low leverage as this still leaves room for improvement if the company were to take on more debt. A high debt company having a low ROE is a different story altogether and a risky investment in our books. Our risks dashboard should have the 4 risks we have identified for Keg Royalties Income Fund.
How Does Debt Impact Return On Equity?
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.
Keg Royalties Income Fund's Debt And Its 4.5% ROE
It's worth noting the high use of debt by Keg Royalties Income Fund, leading to its debt to equity ratio of 1.51. The combination of a rather low ROE and significant use of debt is not particularly appealing. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.