One of the best investments we can make is can eating too many popsicles kill youin our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. To keep the lesson grounded in practicality, we’ll use ROE to better understand Xchanging Solutions Limited (

NSE:XCHANGING

).

Xchanging Solutions has a ROE of 8.2%

, based on the last twelve months. One way to conceptualize this, is that for each ₹1 of shareholders’ equity it has, the company made ₹0.082 in profit.

View our latest analysis for Xchanging Solutions

How Do You Calculate ROE?

The

formula for return on equity

is:

Return on Equity = Net Profit ÷ Shareholders’ Equity

Or for Xchanging Solutions:

8.2% = 316.4 ÷ ₹3.8b (Based on the trailing twelve months to March 2018.)

Most readers would understand what net profit is, but it’s worth explaining the concept of shareholders’ equity. It is all the money paid into the company from shareholders, plus any earnings retained. You can calculate shareholders’ equity by subtracting the company’s total liabilities from its total assets.

What Does Return On Equity Mean?

ROE measures a company’s profitability against the profit it retains, and any outside investments. The ‘return’ is the amount earned after tax over the last twelve months. A higher profit will lead to a higher ROE. 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 Xchanging Solutions 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. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. If you look at the image below, you can see Xchanging Solutions has a lower ROE than the average (11%) in the IT industry classification.

NSEI:XCHANGING Last Perf January 1st 19

Unfortunately, that’s sub-optimal. It is better when the ROE is above industry average, but a low one doesn’t necessarily mean the business is overpriced. Still,

shareholders might want to check if insiders have been selling

.

The Importance Of Debt To 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 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. That will make the ROE look better than if no debt was used.

Story continues

Xchanging Solutions’s Debt And Its 8.2% ROE

Although Xchanging Solutions does use a little debt, its debt to equity ratio of just 0.00028 is very low. Its ROE is rather low, and it does use some debt, albeit not much. That’s not great to see. 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.

But It’s Just One Metric

Return on equity is a useful indicator of the ability of a business to generate profits and return them to shareholders. Companies that can achieve high returns on equity without too much debt are generally of good quality. All else being equal, a higher ROE is better.

But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. It is important to consider other factors, such as future profit growth — and how much investment is required going forward. So I think it may be worth checking this

free

this

detailed graph

of past earnings, revenue and cash flow

.

But note:

Xchanging Solutions may not be the best stock to buy

. So take a peek at this

free

list of interesting companies with high ROE and low debt.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at

[email protected]

.

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