Should We Be Delighted With China Nature Energy Technology Holdings Limited's (HKG:1597) ROE Of 40%?

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 China Nature Energy Technology Holdings Limited (HKG:1597), 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. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

See our latest analysis for China Nature Energy Technology Holdings

How Is ROE Calculated?

The formula for ROE is:

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

So, based on the above formula, the ROE for China Nature Energy Technology Holdings is:

40% = CN¥43m ÷ CN¥106m (Based on the trailing twelve months to December 2019).

The 'return' refers to a company's earnings over the last year. One way to conceptualize this is that for each HK$1 of shareholders' capital it has, the company made HK$0.40 in profit.

Does China Nature Energy Technology Holdings Have A Good ROE?

Arguably the easiest way to assess company's ROE is to compare it with the average in its industry. However, this method is only useful as a rough check, because companies do differ quite a bit within the same industry classification. As you can see in the graphic below, China Nature Energy Technology Holdings has a higher ROE than the average (5.9%) in the Electrical industry.

That's what we like to see. Bear in mind, a high ROE doesn't always mean superior financial performance. A higher proportion of debt in a company's capital structure may also result in a high ROE, where the high debt levels could be a huge risk . To know the 3 risks we have identified for China Nature Energy Technology Holdings visit our risks dashboard for free.

The Importance Of Debt To Return On Equity

Most companies need money -- from somewhere -- to grow their profits. The cash for investment can come from prior year profits (retained earnings), issuing new shares, or borrowing. 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.

China Nature Energy Technology Holdings' Debt And Its 40% ROE

China Nature Energy Technology Holdings has a debt to equity ratio of 0.88, which is far from excessive. When I see a high ROE, fuelled by only modest debt, I suspect the business is high quality. Conservative use of debt to boost returns is usually a good move for shareholders, though it does leave the company more exposed to interest rate rises.

Summary

Return on equity is one way we can compare its business quality of different companies. In our books, the highest quality companies have high return on equity, despite low debt. If two companies have the same ROE, then I would generally prefer the one with less debt.

But when a business is high quality, the market often bids it up to a price that reflects this. It is important to consider other factors, such as future profit growth -- and how much investment is required going forward. Check the past profit growth by China Nature Energy Technology Holdings by looking at this visualization of past earnings, revenue and cash flow.

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.

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