While some investors are already well versed in financial metrics (hat tip),first bank business loan 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 Michael Hill International Limited (

ASX:MHJ

).

Over the last twelve months

Michael Hill International has recorded a ROE of 18%

. One way to conceptualize this, is that for each A$1 of shareholders’ equity it has, the company made A$0.18 in profit.

View our latest analysis for Michael Hill International

How Do You Calculate Return On Equity?

The

formula for return on equity

is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for Michael Hill International:

18% = 34.818 ÷ AU$189m (Based on the trailing twelve months to June 2018.)

Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is all the money paid into the company from shareholders, plus any earnings retained. The easiest way to calculate shareholders’ equity is to subtract the company’s total liabilities from the total assets.

What Does Return On Equity Signify?

ROE looks at the amount a company earns relative to the money it has kept within the business. The ‘return’ is the profit over the last twelve months. That means that the higher the ROE, the more profitable the company is. So, all else equal,

investors should like a high ROE

. That means ROE can be used to compare two businesses.

Does Michael Hill International 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 is clear from the image below, Michael Hill International has a better ROE than the average (13%) in the Specialty Retail industry.

ASX:MHJ Last Perf January 3rd 19

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?

Virtually all companies need money to invest in the business, to grow 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 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.

Story continues

Michael Hill International’s Debt And Its 18% ROE

Michael Hill International has a debt to equity ratio of 0.19, which is far from excessive. The fact that it achieved a fairly good ROE with only modest debt suggests the business might be worth putting on your watchlist. Conservative use of debt to boost returns is usually a good move for shareholders, though it does leave the company more exposed to interest rate rises.

The Bottom Line On ROE

Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. A company that can achieve a high return on equity without debt could be considered a high quality business. All else being equal, a higher ROE is better.

But when a business is high quality, the market often bids it up to a price that reflects this. It is important to consider other factors, such as future profit growth — and how much investment is required going forward. So I think it may be worth checking this

free

report on analyst forecasts for the company

.

If you would prefer check out another company — one with potentially superior financials — then do not miss this

free

list of interesting companies, that have HIGH return on equity 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

[email protected]

.

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