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 Medexus Pharmaceuticals Inc. (TSE:MDP), 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. Put another way, it reveals the company's success at turning shareholder investments into profits.

Check out our latest analysis for Medexus Pharmaceuticals

How To 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 Medexus Pharmaceuticals is:

20% = US$5.9m ÷ US$30m (Based on the trailing twelve months to December 2023).

The 'return' is the income the business earned over the last year. Another way to think of that is that for every CA$1 worth of equity, the company was able to earn CA$0.20 in profit.

Does Medexus Pharmaceuticals 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. Importantly, this is far from a perfect measure, because companies differ significantly within the same industry classification. You can see in the graphic below that Medexus Pharmaceuticals has an ROE that is fairly close to the average for the Pharmaceuticals industry (21%).

So while the ROE is not exceptional, at least its acceptable. 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. Our risks dashboardshould have the 3 risks we have identified for Medexus Pharmaceuticals.

The Importance Of Debt To 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 case of the first and second options, the ROE will reflect this use of cash, for growth. 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.

Medexus Pharmaceuticals' Debt And Its 20% ROE

Medexus Pharmaceuticals clearly uses a high amount of debt to boost returns, as it has a debt to equity ratio of 1.75. While its ROE is respectable, it is worth keeping in mind that there is usually a limit as to how much debt a company can use. Debt increases risk and reduces options for the company in the future, so you generally want to see some good returns from using it.