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. By way of learning-by-doing, we'll look at ROE to gain a better understanding of Energiekontor AG (ETR:EKT).

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

See our latest analysis for Energiekontor

How Do You Calculate Return On Equity?

The formula for return on equity is:

Return on Equity = Net Profit (from continuing operations) ÷ Shareholders' Equity

So, based on the above formula, the ROE for Energiekontor is:

44% = €57m ÷ €128m (Based on the trailing twelve months to June 2023).

The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every €1 worth of equity, the company was able to earn €0.44 in profit.

Does Energiekontor Have A Good ROE?

Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. As is clear from the image below, Energiekontor has a better ROE than the average (14%) in the Electrical industry.

That's clearly a positive. With that said, a high ROE doesn't always indicate high profitability. Aside from changes in net income, a high ROE can also be the outcome of high debt relative to equity, which indicates risk.

Why You Should Consider Debt When Looking At ROE

Most companies need money -- from somewhere -- to grow their 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. That will make the ROE look better than if no debt was used.

Energiekontor's Debt And Its 44% ROE

It seems that Energiekontor uses a huge volume of debt to fund the business, since it has an extremely high debt to equity ratio of 3.18. So although the company has an impressive ROE, the company might not have been able to achieve this without the significant use of debt.

Summary

Return on equity is useful for comparing the quality of different businesses. 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.