Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). We'll use ROE to examine Shenma Industry Co.Ltd (SHSE:600810), 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. Put another way, it reveals the company's success at turning shareholder investments into profits.

How Do You Calculate Return On Equity?

ROE 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 Shenma IndustryLtd is:

2.6% = CN¥303m ÷ CN¥12b (Based on the trailing twelve months to June 2024).

The 'return' is the yearly profit. That means that for every CN¥1 worth of shareholders' equity, the company generated CN¥0.03 in profit.

Does Shenma IndustryLtd Have A Good ROE?

One simple way to determine if a company has a good return on equity is to compare it to the average for 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, Shenma IndustryLtd has a lower ROE than the average (6.4%) in the Chemicals industry classification.

That's not what we like to see. That being said, a low ROE is not always a bad thing, especially if the company has low leverage as this still leaves room for improvement if the company were to take on more debt. A company with high debt levels and low ROE is a combination we like to avoid given the risk involved. Our risks dashboard should have the 3 risks we have identified for Shenma IndustryLtd.

How Does Debt Impact Return On Equity?

Most companies need money -- from somewhere -- to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. In the case of the first and second options, the ROE will reflect this use of cash, for growth. In the latter case, the debt required for growth will boost returns, but will not impact the shareholders' equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.

Combining Shenma IndustryLtd's Debt And Its 2.6% Return On Equity

Shenma IndustryLtd clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.35. Its ROE is quite low, even with the use of significant debt; that's not a good result, in our opinion. 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.

Conclusion

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 around the same level of debt to equity, and one has a higher ROE, I'd generally prefer the one with higher ROE.

Having said that, while ROE is a useful indicator of business quality, you'll have to look at a whole range of factors to determine the right price to buy a stock. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. So you might want to take a peek at this data-rich interactive graph of forecasts for the company.

Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.