One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will explain how we can use return on equity (ROE) to better understand a business. We will use ROE to examine Creotech Instruments SA (WSE:CRI), as a concrete example.
ROE or return on equity is a useful tool for evaluating how effectively a company can generate returns on the investment it has received from its shareholders. In simple terms, it is used to assess the profitability of a company in relation to its equity.
Check out our latest analysis for Creotech Instruments
How is ROE calculated?
the return on equity formula is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the formula above, the ROE for Creotech Instruments is:
3.2% = 595,000 zł ÷ 18 million zł (based on the last twelve months until December 2021).
The “return” is the annual profit. This means that for every 1 PLN worth of equity, the company has generated 0.03 PLN of profit.
Does Creotech Instruments have a good ROE?
Perhaps the easiest way to assess a company’s ROE is to compare it to the industry average. However, this method is only useful as a rough check, as companies differ quite a bit within the same industry classification. As shown in the graph below, Creotech Instruments has an ROE below the average (10%) of the Aerospace and Defense industry classification.
Unfortunately, this is suboptimal. However, we believe that a lower ROE could still mean that a company has the opportunity to improve its returns through the use of leverage, provided its existing debt levels are low. A highly leveraged company with a low ROE is a whole other story and a risky investment on our books. You can see the 5 risks we have identified for Creotech Instruments by visiting our risk dashboard for free on our platform here.
What is the impact of debt on ROE?
Virtually all businesses need money to invest in the business, to increase their profits. The money for the investment can come from the previous year’s earnings (retained earnings), from issuing new shares or from borrowing. In the case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, debt used for growth will enhance returns, but will not affect total equity. So using debt can improve ROE, but with the added risk of stormy weather, metaphorically speaking.
Creotech Instruments’ debt and its ROE of 3.2%
Creotech Instruments has a debt ratio of 0.26, which is far from excessive. Its ROE is pretty low and it uses some debt, but not a lot. It’s not great to see. Prudent use of debt to boost returns is generally a good move for shareholders, even if it leaves the company more exposed to rising interest rates.
Return on equity is a useful indicator of a company’s ability to generate profits and return them to shareholders. Companies that can earn high returns on equity without too much debt are generally of good quality. If two companies have the same ROE, I would generally prefer the one with less debt.
But ROE is only one piece of a larger puzzle, as high-quality companies often trade on high earnings multiples. The rate at which earnings are likely to grow, relative to earnings growth expectations reflected in the current price, should also be considered. So I think it’s worth checking it out free this detailed graph past profits, revenue and cash flow.
Sure Creotech Instruments may not be the best stock to buy. So you might want to see this free collection of other companies that have high ROE and low debt.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.