Did Zhongyu Energy Holdings Limited (HKG:3633) Use Debt To Deliver Its ROE Of 17%?

Many investors are still learning about the various metrics that can be useful when analysing a stock. This article is for those who would like to learn about Return On Equity (ROE). We'll use ROE to examine Zhongyu Energy Holdings Limited (HKG:3633), by way of a worked example.

Return on equity or ROE is a key measure used to assess how efficiently a company's management is utilizing the company's capital. In other words, it is a profitability ratio which measures the rate of return on the capital provided by the company's shareholders.

See our latest analysis for Zhongyu Energy Holdings

How Do You Calculate Return On Equity?

The formula for ROE is:

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

So, based on the above formula, the ROE for Zhongyu Energy Holdings is:

17% = HK$1.2b ÷ HK$7.5b (Based on the trailing twelve months to June 2021).

The 'return' refers to a company's earnings over the last year. Another way to think of that is that for every HK$1 worth of equity, the company was able to earn HK$0.17 in profit.

Does Zhongyu Energy Holdings Have A Good Return On Equity?

By comparing a company's ROE with its industry average, we can get a quick measure of how good it is. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. The image below shows that Zhongyu Energy Holdings has an ROE that is roughly in line with the Gas Utilities industry average (15%).

So while the ROE is not exceptional, at least its acceptable. Even if the ROE is respectable when compared to the industry, its worth checking if the firm's ROE is being aided by high debt levels. If true, then it is more an indication of risk than the potential. To know the 2 risks we have identified for Zhongyu Energy Holdings visit our risks dashboard for free.

How Does Debt Impact 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. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.

Zhongyu Energy Holdings' Debt And Its 17% ROE

Zhongyu Energy Holdings does use a high amount of debt to increase returns. It has a debt to equity ratio of 1.52. There's no doubt its ROE is decent, but the very high debt the company carries is not too exciting to see. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.

Summary

Return on equity is one way we can compare its business quality of different companies. Companies that can achieve high returns on equity without too much debt are generally of good quality. If two companies have the same ROE, then I would generally prefer the one with less debt.

But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. 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 Zhongyu Energy Holdings by looking at this visualization of past earnings, revenue and cash flow.

Of course Zhongyu Energy Holdings may not be the best stock to buy. So you may wish to see this free collection of other companies that have high ROE and low debt.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.