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While some investors are already well versed in financial metrics (hat tip), this article is for those who would like to learn about Return On Equity (ROE) and why it is important. By way of learning-by-doing, we'll look at ROE to gain a better understanding of Reckon Limited (ASX:RKN).
Our data shows Reckon has a return on equity of 49% for the last year. That means that for every A$1 worth of shareholders' equity, it generated A$0.49 in profit.
Check out our latest analysis for Reckon
How Do You Calculate Return On Equity?
The formula for return on equity is:
Return on Equity = Net Profit ÷ Shareholders' Equity
Or for Reckon:
49% = AU$7.7m ÷ AU$16m (Based on the trailing twelve months to December 2018.)
Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is all earnings retained by the company, plus any capital paid in by shareholders. The easiest way to calculate shareholders' equity is to subtract the company's total liabilities from the total assets.
What Does Return On Equity Signify?
ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the yearly profit. The higher the ROE, the more profit the company is making. So, all else being equal, a high ROE is better than a low one. That means ROE can be used to compare two businesses.
Does Reckon 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. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. Pleasingly, Reckon has a superior ROE than the average (18%) company in the Software industry.
That's what I like to see. We think a high ROE, alone, is usually enough to justify further research into a company. For example you might check if insiders are buying shares.
Why You Should Consider Debt When Looking At ROE
Most companies need money -- from somewhere -- to grow their profits. That cash can come from issuing shares, retained earnings, 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.
Reckon's Debt And Its 49% ROE
It's worth noting the significant use of debt by Reckon, leading to its debt to equity ratio of 2.88. There's no doubt its ROE is impressive, but the company appears to use its debt to boost that metric. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.