One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will discuss how we can use Return on Equity (ROE) to better understand a business. As a learning by doing, we will look at the ROE to better understand Guangdong Tannery Limited (HKG: 1058).

Return on equity or ROE is a test of how effectively a company increases its value and manages investor money. In simpler terms, it measures a company’s profitability relative to equity.

See our latest analysis for Guangdong Tannery

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, the ROE of Guangdong Tannery is:

11% = HK $ 2.9 million ÷ HK $ 26 million (based on the last twelve months to June 2021).

The “return” is the income the business has earned over the past year. One way to conceptualize this is that for every HK $ 1 of shareholder capital it has, the company has made HK $ 0.11 in profit.

Does Guangdong tannery have good ROE?

Perhaps the easiest way to assess a company’s ROE is to compare it to the industry average. It is important to note that this measure is far from perfect, as companies differ considerably within a single industry classification. As you can see in the graph below, Guangdong Tannery has an above-average ROE (7.5%) for the luxury industry.

SEHK: 1058 Return on equity September 30, 2021

This is what we love to see. 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. To learn about the 4 risks we have identified for Guangdong Tannery visit our free risk dashboard.

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 case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the debt used for growth will improve returns, but will not affect total equity. So, using debt can improve ROE, but with added risk in stormy weather, metaphorically speaking.

Guangdong Tannery’s debt and its 11% ROE

It appears that Guangdong Tannery is using a huge volume of debt to fund the business because it has an extremely high debt ratio of 5.43. We consider it a negative sign when a company has a fairly low ROE despite a fairly high debt-to-equity ratio.

Conclusion

Return on equity is useful for comparing the quality of different companies. A business that can earn a high return on equity without going into debt could be considered a high quality business. All other things being equal, a higher ROE is preferable.

But when a company is of high quality, the market often offers it up to a price that reflects that. 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 this detailed graphic past profits, income and cash flow.

But beware : Guangdong Tannery 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.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.

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