While some investors are already familiar with financial metrics (hat tip), this article is for those who want to learn more about return on equity (ROE) and why it is important. As a learning by doing, we will look at the ROE to better understand GR Infraprojects Limited (NSE: GRINFRA).

Return on equity or ROE is an important factor for a shareholder to consider because it tells them how effectively their capital is being reinvested. In other words, it is a profitability ratio that measures the rate of return on capital contributed by the shareholders of the company.

See our latest review for GR Infraprojects

How do you calculate return on equity?

The return on equity formula is:

Return on equity = Net income (from continuing operations) ÷ Equity

Thus, based on the above formula, the ROE of the GR Infraprojects is:

27% = ₹ 11b ÷ ₹ 40b (based on the last twelve months up to June 2021).

The “return” is the income the business has earned over the past year. So this means that for every 1 of its shareholder’s investments, the company generates a profit of ₹ 0.27.

Does GR Infraprojects have a good return on equity?

By comparing a company’s ROE with its industry average, we can get a quick measure of its quality. It is important to note that this measure is far from perfect, as companies differ considerably within a single industry classification. As you can see in the graph below, GR Infraprojects has an above-average ROE (7.9%) for the construction industry.

It’s a good sign. Keep in mind that a high ROE doesn’t always mean superior financial performance. A higher proportion of debt in a company’s capital structure can also result in high ROE, where high debt levels could represent a huge risk.

What is the impact of debt on ROE?

Businesses generally need to invest money to increase their profits. This liquidity can come from retained earnings, the issuance of new shares (shares) 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 returns, but will not affect equity. This will make the ROE better than if no debt was used.

Combine GR Infraprojects’ debt and its 27% return on equity

GR Infraprojects clearly uses a high amount of debt to increase returns, as it has a debt-to-equity ratio of 1.14. Its ROE is quite impressive, but it probably would have been lower without the use of debt. Investors should think carefully about how a business will perform if it weren’t able to borrow so easily, as credit markets change over time.

Conclusion

Return on equity is a useful indicator of a company’s ability to generate profits and return them to shareholders. Firms that can earn high returns on equity without taking on too much debt are generally of good quality. If two companies have the same ROE, then I would generally prefer the one with the least amount of debt.

But ROE is only one piece of a bigger puzzle, as high-quality companies often trade at high earnings multiples. Especially important to consider are the growth rates of earnings, relative to expectations reflected in the share price. Check out GR Infraprojects’ past earnings growth by looking at this visualization of past earnings, income, and cash flow.

If you would rather consult with another company – one with potentially superior finances – then don’t miss this free list of interesting companies, which have a HIGH return on equity and low leverage.

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

Do you have any feedback on this item? Are you worried about the content? Get in touch with us directly. You can also send an email to the editorial team (at) simplywallst.com.