While some investors are already familiar with financial metrics (hat tip), this article is for those who want to learn more about return on equity (ROE) and why it’s important. As a learning-by-doing, we’ll take a look at the ROE to better understand Inventronics Limited (CVE: IVX).
Return on equity or ROE is a test of how effectively a company increases its value and manages investor money. In short, the ROE shows the profit that each dollar generates compared to the investments of its shareholders.
Check out our latest review for Inventronics
How to calculate return on equity?
the return on equity formula is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, Inventronics’ ROE is:
55% = CA $ 821,000 ÷ CA $ 1.5 million (based on the last twelve months up to March 2021).
The “return” is the profit of the last twelve months. Another way to look at this is that for every CAD $ 1 worth of equity, the company was able to make CAD $ 0.55 in profit.
Does Inventronics have a good return on equity?
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 a lot within a single industry classification. Fortunately, Inventronics has an above-average ROE (18%) for the construction industry.
This is clearly positive. That said, high ROE doesn’t always indicate high profitability. Besides changes in net income, high ROE can also be the result of high leverage to equity, which indicates risk. You can see the 3 risks we have identified for Inventronics by visiting our risk dashboard for free on our platform here.
What is the impact of debt on ROE?
Businesses generally need to invest money to increase their profits. This liquidity can come from retained earnings, the issuance of new shares (shares) or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the debt used for growth will improve returns, but will not affect total equity. This will make the ROE better than if no debt was used.
Combine Inventronics Debt and its 55% Return on Equity
Noteworthy is Inventronics’ high reliance on debt, leading to its debt-to-equity ratio of 1.42. While there is no doubt that their ROE is impressive, we would have been even more impressed if the company had achieved that goal with lower debt. Debt comes with additional risk, so it’s only really worth it when a business is making decent returns from it.
Return on equity is a useful indicator of a company’s ability to generate profits and return them to shareholders. In our books, the highest quality companies have a high return on equity, despite low leverage. If two companies have roughly the same level of debt to equity and one has a higher ROE, I would generally prefer the one with a higher ROE.
But ROE is only one piece of a bigger puzzle, as high-quality companies often trade at high earnings multiples. It’s important to take other factors into account, such as future profit growth – and the amount of investment needed in the future. Check out Inventronics’ past earnings growth by looking at this visualization of past earnings, revenue, and cash flow.
Of course Inventronics may not be the best stock to buy. So you might want to see this free collection of other companies with high ROE and low leverage.
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