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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. We'll use ROE to examine Frontline plc (NYSE:FRO), by way of a worked example.
Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.
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How Do You 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 Frontline is:
21% = US$496m ÷ US$2.3b (Based on the trailing twelve months to December 2024).
The 'return' is the amount earned after tax over the last twelve months. Another way to think of that is that for every $1 worth of equity, the company was able to earn $0.21 in profit.
See our latest analysis for Frontline
Does Frontline Have A Good ROE?
Arguably the easiest way to assess company's ROE is to compare it with the average in 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, Frontline has a superior ROE than the average (14%) in the Oil and Gas industry.
That's clearly a positive. With that said, a high ROE doesn't always indicate high profitability. Aside from changes in net income, a high ROE can also be the outcome of high debt relative to equity, which indicates risk. You can see the 4 risks we have identified for Frontline by visiting our risks dashboard for free on our platform here.
The Importance Of Debt To Return On Equity
Most companies need money -- from somewhere -- to grow their profits. That cash can come from retained earnings, issuing new shares (equity), 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 use of debt will improve the returns, but will not change the equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.
Frontline's Debt And Its 21% ROE
It's worth noting the high use of debt by Frontline, leading to its debt to equity ratio of 1.38. There's no doubt its ROE is decent, but the very high debt the company carries is not too exciting to see. Investors should think carefully about how a company might perform if it was unable to borrow so easily, because credit markets do change over time.
