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 XP Power Limited (LON:XPP), by way of a worked example.

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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.

Check out our latest analysis for XP Power

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 XP Power is:

18% = UK£24m ÷ UK£132m (Based on the trailing twelve months to June 2023).

The 'return' is the income the business earned over the last year. So, this means that for every £1 of its shareholder's investments, the company generates a profit of £0.18.

Does XP Power Have A Good Return On Equity?

One simple way to determine if a company has a good return on equity is to compare it to the average for its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. As is clear from the image below, XP Power has a better ROE than the average (11%) in the Electrical industry.

That's what we like to see. With that said, a high ROE doesn't always indicate high profitability. Aside from changes in net income, a high ROE can also be the outcome of high debt relative to equity, which indicates risk. You can see the 2 risks we have identified for XP Power by visiting our risks dashboard for free on our platform here.

How Does Debt Impact ROE?

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 case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the debt required for growth will boost returns, but will not impact the shareholders' equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.

Combining XP Power's Debt And Its 18% Return On Equity

It's worth noting the high use of debt by XP Power, leading to its debt to equity ratio of 1.33. There's no doubt its ROE is decent, but the very high debt the company carries is not too exciting to see. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.