One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will discuss how we can use Return on Equity (ROE) to better understand a business. To keep the lesson grounded in practice, we will use the ROE to better understand Neogen Chemicals Limited (NSE: NEOGEN).

ROE or return on equity is a useful tool to assess how effectively a company can generate the returns on investment it has received from its shareholders. Simply put, it is used to assess a company’s profitability against its equity.

See our latest review for Neogen Chemicals

How to calculate return on equity?

Return on equity can be calculated using the formula:

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

So, based on the above formula, the ROE of Neogen Chemicals is:

19% = ₹ 364m ₹ 2.0b (Based on the last twelve months up to September 2021).

The “return” is the annual profit. Another way to look at this is that for every 1 value of equity, the company was able to make ₹ 0.19 in profit.

Does Neogen Chemicals have a good ROE?

An easy way to determine if a company has a good return on equity is to compare it to the average in its industry. However, this method is only useful as a rough check, as companies differ a lot within a single industry classification. As you can see in the graph below, Neogen Chemicals has an above-average ROE (15%) for the chemical industry.

It’s a good sign. That said, a high ROE doesn’t always indicate high profitability. 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. You can see the 3 risks we have identified for Neogen Chemicals by visiting our risk dashboard for free on our platform here.

What is the impact of debt on ROE?

Most businesses need the money – somewhere – to increase their profits. This liquidity can come from retained earnings, the issuance of new shares (equity) or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the debt used for growth will improve returns, but will not affect total equity. This will make the ROE better than if no debt was used.

Combine Neogen Chemicals’ debt and its 19% return on equity

Noteworthy is the high reliance on debt by Neogen Chemicals, leading to its debt-to-equity ratio of 1.37. While its ROE is respectable, it should be borne in mind that there is usually a limit on how much debt a business can use. 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 one way to compare the business quality of different companies. Firms that can earn high returns on equity without taking on too much debt are generally of good quality. If two companies have roughly the same level of debt to equity and one has a higher ROE, I would generally prefer the one with a higher ROE.

But ROE is only one piece of a bigger puzzle, as high-quality companies often trade at high earnings multiples. It is important to take into account other factors, such as future profit growth and the amount of investment required for the future. So I think it’s worth checking this out free analyst forecast report for the company.

Sure Neogen Chemicals May Not Be The Best Stock To Buy. So you might want to see this free collection of other companies with high ROE and low leverage.

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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 any stock 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 documents. Simply Wall St has no position in any of the stocks mentioned.