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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. To keep the lesson grounded in practicality, we'll use ROE to better understand Aurizon Holdings Limited (ASX:AZJ).
Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In short, ROE shows the profit each dollar generates with respect to its shareholder investments.
View our latest analysis for Aurizon Holdings
How To Calculate Return On Equity?
Return on equity can be calculated by using the formula:
Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity
So, based on the above formula, the ROE for Aurizon Holdings is:
9.0% = AU$386m ÷ AU$4.3b (Based on the trailing twelve months to December 2022).
The 'return' is the profit over the last twelve months. That means that for every A$1 worth of shareholders' equity, the company generated A$0.09 in profit.
Does Aurizon Holdings Have A Good Return On Equity?
Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. You can see in the graphic below that Aurizon Holdings has an ROE that is fairly close to the average for the Transportation industry (9.0%).
That's neither particularly good, nor bad. While at least the ROE is not lower than the industry, its still worth checking what role the company's debt plays as high debt levels relative to equity may also make the ROE appear high. If so, this increases its exposure to financial risk. Our risks dashboardshould have the 4 risks we have identified for Aurizon Holdings.
Why You Should Consider Debt When Looking At ROE
Companies usually need to invest money to grow their profits. That cash can come from issuing shares, retained earnings, or debt. In the first and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the debt used for growth will improve returns, but won't affect the total equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Combining Aurizon Holdings' Debt And Its 9.0% Return On Equity
It's worth noting the high use of debt by Aurizon Holdings, leading to its debt to equity ratio of 1.32. The combination of a rather low ROE and significant use of debt is not particularly appealing. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.