Should You Be Excited About Northland Power Inc.'s (TSE:NPI) 30% Return On Equity?

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 Northland Power Inc. (TSE:NPI), by way of a worked example.

Northland Power has a ROE of 30%, based on the last twelve months. Another way to think of that is that for every CA$1 worth of equity in the company, it was able to earn CA$0.30.

View our latest analysis for Northland Power

How Do I Calculate Return On Equity?

The formula for return on equity is:

Return on Equity = Net Profit ÷ Shareholders' Equity

Or for Northland Power:

30% = CA$299m ÷ CA$1.5b (Based on the trailing twelve months to June 2019.)

Most know that net profit is the total earnings after all expenses, but the concept of shareholders' equity is a little more complicated. It is all the money paid into the company from shareholders, plus any earnings retained. You can calculate shareholders' equity by subtracting the company's total liabilities from its total assets.

What Does Return On Equity Mean?

ROE looks at the amount a company earns relative to the money it has kept within the business. The 'return' is the profit over the last twelve months. The higher the ROE, the more profit the company is making. So, as a general rule, a high ROE is a good thing. That means it can be interesting to compare the ROE of different companies.

Does Northland Power Have A Good ROE?

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. As is clear from the image below, Northland Power has a better ROE than the average (9.9%) in the Renewable Energy industry.

That's what I like to see. We think a high ROE, alone, is usually enough to justify further research into a company. For example, I often check if insiders have been buying shares .

How Does Debt Impact Return On Equity?

Companies usually need to invest money to grow their profits. That cash can come from retained earnings, issuing 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 won't affect the total equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.

Northland Power's Debt And Its 30% ROE

We think Northland Power uses a lot of debt to boost returns, as it has a relatively high debt to equity ratio of 5.23. Its ROE is no doubt quite impressive, but it would probably be a lot lower without the use of significant leverage.

The Key Takeaway

Return on equity is one way we can compare the business quality of different companies. 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.

But when a business is high quality, the market often bids it up to a price that reflects this. The rate at which profits are likely to grow, relative to the expectations of profit growth reflected in the current price, must be considered, too. So you might want to take a peek at this data-rich interactive graph of forecasts for the company.

If you would prefer check out another company -- one with potentially superior financials -- then do not miss this free list of interesting companies, that have HIGH return on equity and low debt.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.