While some investors are already well versed in financial metrics (hat tip),what should a moisture meter read at sill plate 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 Kilitch Drugs (India) Limited (

NSE:KILITCH

).

Over the last twelve months

Kilitch Drugs (India) has recorded a ROE of 4.6%

. Another way to think of that is that for every ₹1 worth of equity in the company, it was able to earn ₹0.046.

See our latest analysis for Kilitch Drugs (India)

How Do You Calculate ROE?

The

formula for return on equity

is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for Kilitch Drugs (India):

4.6% = 51.524 ÷ ₹1.1b (Based on the trailing twelve months to March 2018.)

It’s easy to understand the ‘net profit’ part of that equation, but ‘shareholders’ equity’ requires further explanation. It is the capital paid in by shareholders, plus any retained earnings. You can calculate shareholders’ equity by subtracting the company’s total liabilities from its 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 profit over the last twelve months. That means that the higher the ROE, the more profitable the company is. So, all else being equal,

a high ROE is better than a low one

. That means it can be interesting to compare the ROE of different companies.

Does Kilitch Drugs (India) 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As shown in the graphic below, Kilitch Drugs (India) has a lower ROE than the average (11%) in the Pharmaceuticals industry classification.

NSEI:KILITCH Past Revenue and Net Income, March 1st 2019

That certainly isn’t ideal. We’d prefer see an ROE above the industry average, but it might not matter if the company is undervalued. Nonetheless, it might be wise to

check if insiders have been selling

.

How Does Debt Impact Return On Equity?

Companies usually need to invest money to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. 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.

Story continues

Kilitch Drugs (India)’s Debt And Its 4.6% ROE

Although Kilitch Drugs (India) does use a little debt, its debt to equity ratio of just 0.0082 is very low. Its ROE is certainly on the low side, and since it already uses debt, we’re not too excited about the company. Conservative use of debt to boost returns is usually a good move for shareholders, though it does leave the company more exposed to interest rate rises.

The Key Takeaway

Return on equity is useful for comparing the quality of different businesses. A company that can achieve a high return on equity without debt could be considered a high quality business. If two companies have the same ROE, then I would generally prefer the one with less debt.

But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. Profit growth rates, versus the expectations reflected in the price of the stock, are a particularly important to consider. So I think it may be worth checking this

free

this

detailed graph

of past earnings, revenue and cash flow

.

Of course

Kilitch Drugs (India) may not be the best stock to buy

. So you may wish to see this

free

collection of other companies that have high ROE and low debt.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at

[email protected]

. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.

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