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). To keep the lesson grounded in practicality, we’ll use ROE to better understand Ushanti Colour Chem Limited (NSE:UCL).

Our data shows Ushanti Colour Chem has a return on equity of 26% for the last year. One way to conceptualize this, is that for each ₹1 of shareholders’ equity it has, the company made ₹0.26 in profit.

View our latest analysis for Ushanti Colour Chem

How Do I Calculate Return On Equity?

The formula for return on equity is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for Ushanti Colour Chem:

26% = 24.460928 ÷ ₹94m (Based on the trailing twelve months to March 2018.)

Most know that net profit is the total earnings after all expenses, but the concept of shareholders’ equity is a little more complicated. 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 ROE Mean?

ROE measures a company’s profitability against the profit it retains, and any outside investments. The ‘return’ is the yearly profit. That means that the higher the ROE, the more profitable the company is. So, all else being equal, a high ROE is better than a low one. Clearly, then, one can use ROE to compare different companies.

Does Ushanti Colour Chem 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, Ushanti Colour Chem has a better ROE than the average (13%) in the Chemicals industry.

That is a good sign. I usually take a closer look when a company has a better ROE than industry peers. For example, I often check if insiders have been buying shares .

How Does Debt Impact ROE?

Most companies need money — from somewhere — 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 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.

Ushanti Colour Chem’s Debt And Its 26% ROE

It’s worth noting the significant use of debt by Ushanti Colour Chem, leading to its debt to equity ratio of 1.41. while its ROE is respectable, it is worth keeping in mind that there is usually a limit to how much debt a company can use. 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.

The Key Takeaway

Return on equity is one way we can compare the business quality of different companies. Companies that can achieve high returns on equity without too much debt are generally of good quality. All else being equal, a higher ROE is better.

But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. 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 Ushanti Colour Chem 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.