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. We'll use ROE to examine Baltic Classifieds Group PLC (LON:BCG), by way of a worked example.

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. Simply put, it is used to assess the profitability of a company in relation to its equity capital.

View our latest analysis for Baltic Classifieds Group

How Is ROE Calculated?

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 Baltic Classifieds Group is:

8.1% = €27m ÷ €334m (Based on the trailing twelve months to October 2023).

The 'return' is the yearly profit. That means that for every ￡1 worth of shareholders' equity, the company generated ￡0.08 in profit.

Does Baltic Classifieds Group Have A Good Return On Equity?

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. If you look at the image below, you can see Baltic Classifieds Group has a similar ROE to the average in the Interactive Media and Services industry classification (8.1%).

That's neither particularly good, nor bad. Although the ROE is similar to the industry, we should still perform further checks to see if the company's ROE is being boosted by high debt levels. If a company takes on too much debt, it is at higher risk of defaulting on interest payments.

How Does Debt Impact Return On Equity?

Most companies need money -- from somewhere -- to grow their profits. That cash can come from issuing shares, retained earnings, or debt. In the first two cases, the ROE will capture this use of capital to grow. In the latter case, the use of debt will improve the returns, but will not change the equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.

Combining Baltic Classifieds Group's Debt And Its 8.1% Return On Equity

Baltic Classifieds Group has a debt to equity ratio of 0.16, which is far from excessive. Its ROE isn't particularly impressive, but the debt levels are quite modest, so the business probably has some real potential. Judicious use of debt to improve returns can certainly be a good thing, although it does elevate risk slightly and reduce future optionality.