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 matters. As a learning by doing, we will look at the ROE to better understand Laxmi Organic Industries Limited (NSE: LXCHEM).
Return on equity or ROE is a test of how effectively a company increases its value and manages investor money. In other words, it is a profitability ratio that measures the rate of return on capital contributed by the shareholders of the company.
Check out our latest review for Laxmi Organic Industries
How to calculate return on equity?
the formula for ROE is:
Return on equity = Net income (from continuing operations) ÷ Equity
So, based on the above formula, the ROE of Laxmi Organic Industries is:
12% = ₹ 1.3b ÷ ₹ 10b (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 1 value of equity, the company was able to make 0.12 profit.
Does Laxmi Organic Industries have a good ROE?
Perhaps the easiest way to assess a company’s ROE is to compare it to the industry average. The limitation of this approach is that some companies are very different from others, even within the same industry classification. If you look at the image below, you can see that Laxmi Organic Industries has a ROE similar to the chemical industry classification average (13%).
So even if the ROE is not exceptional, it is at least acceptable. Even though the ROE is respectable compared to the industry, it is worth checking out if the company’s ROE is helped by high debt levels. If a business is too indebted, it runs a greater risk of defaulting on interest. Our risk dashboard should include the 2 risks that we have identified for Laxmi Organic Industries.
What is the impact of debt on return on equity?
Almost all businesses need money to invest in the business, 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. In this way, the use of debt will increase the ROE, even if the basic economy of the business remains the same.
Combine the debt of Laxmi Organic Industries and its return on equity of 12%
Laxmi Organic Industries has a debt ratio of only 0.087 which is very low. Although the ROE is not very impressive, the leverage is modest, which suggests that the company has potential. The prudent use of debt to increase returns is often very good for shareholders. However, this could reduce the company’s ability to take advantage of future opportunities.
Return on equity is useful for comparing the quality of different companies. In our books, the highest quality companies have a high return on equity, despite low leverage. If two companies have the same ROE, then I would generally prefer the one with the least amount of debt.
That said, while ROE is a useful indicator of how good a business is, you’ll need to look at a whole range of factors to determine the right price to buy a stock. Especially important to consider are the growth rates of earnings, relative to expectations reflected in the share price. So I think it’s worth checking this out free analyst forecast report for the company.
But beware : Laxmi Organic Industries may not be the best stock to buy. So take a look at this free list of interesting companies with high ROE and low debt.
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