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While some investors are already well versed in financial metrics (hat tip), 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 RC Fornax Plc (LON:RCFX).
ROE or return on equity is a useful tool to assess how effectively a company can generate returns on the investment it received from its shareholders. Put another way, it reveals the company's success at turning shareholder investments into profits.
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Return on equity 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 RC Fornax is:
16% = UK£610k ÷ UK£3.8m (Based on the trailing twelve months to February 2025).
The 'return' is the profit over the last twelve months. One way to conceptualize this is that for each £1 of shareholders' capital it has, the company made £0.16 in profit.
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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. You can see in the graphic below that RC Fornax has an ROE that is fairly close to the average for the Aerospace & Defense industry (15%).
That isn't amazing, but it is respectable. While at least the ROE is not lower than the industry, its still worth checking what role the company's debt plays as high debt levels relative to equity may also make the ROE appear high. If so, this increases its exposure to financial risk. To know the 3 risks we have identified for RC Fornax visit our risks dashboard for free.
Virtually all companies need money to invest in the business, to grow profits. That cash can come from retained earnings, issuing new shares (equity), 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 debt used for growth will improve returns, but won't affect the total equity. Thus the use of debt can improve ROE, albeit along with extra risk in the case of stormy weather, metaphorically speaking.