Stock Analysis

Did The Indian Hume Pipe Company Limited (NSE:INDIANHUME) Use Debt To Deliver Its ROE Of 6.7%?

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NSEI:INDIANHUME
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One of the best investments we can make is in our own knowledge and skill set. With that in mind, this article will work through how we can use Return On Equity (ROE) to better understand a business. By way of learning-by-doing, we'll look at ROE to gain a better understanding of The Indian Hume Pipe Company Limited (NSE:INDIANHUME).

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 short, ROE shows the profit each dollar generates with respect to its shareholder investments.

Check out our latest analysis for Indian Hume Pipe

How Do You Calculate Return On Equity?

ROE 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 Indian Hume Pipe is:

6.7% = ₹374m ÷ ₹5.6b (Based on the trailing twelve months to September 2020).

The 'return' is the yearly profit. That means that for every ₹1 worth of shareholders' equity, the company generated ₹0.07 in profit.

Does Indian Hume Pipe 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. The limitation of this approach is that some companies are quite different from others, even within the same industry classification. You can see in the graphic below that Indian Hume Pipe has an ROE that is fairly close to the average for the Construction industry (6.4%).

roe
NSEI:INDIANHUME Return on Equity January 21st 2021

That isn't amazing, but it is respectable. 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 so, this increases its exposure to financial risk. You can see the 3 risks we have identified for Indian Hume Pipe by visiting our risks dashboard for free on our platform here.

The Importance Of Debt To Return On Equity

Companies usually need to invest money to grow their profits. That cash can come from issuing shares, retained earnings, or debt. In the first and second cases, the ROE will reflect this use of cash for investment in the business. In the latter case, the debt required for growth will boost returns, but will not impact the shareholders' equity. That will make the ROE look better than if no debt was used.

Indian Hume Pipe's Debt And Its 6.7% ROE

Indian Hume Pipe does use a high amount of debt to increase returns. It has a debt to equity ratio of 1.07. With a fairly low ROE, and significant use of debt, it's hard to get excited about this business at the moment. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.

Conclusion

Return on equity is useful for comparing the quality of different businesses. In our books, the highest quality companies have high return on equity, despite low debt. If two companies have around the same level of debt to equity, and one has a higher ROE, I'd generally prefer the one with higher ROE.

But ROE is just one piece of a bigger puzzle, since high quality businesses often trade on high multiples of earnings. 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. Check the past profit growth by Indian Hume Pipe 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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