With A 2.5% Return On Equity, Is Natural Cool Holdings Limited (Catalist:5IF) A Quality Stock?

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. To keep the lesson grounded in practicality, we'll use ROE to better understand Natural Cool Holdings Limited (Catalist:5IF).

Return on Equity or ROE is a test of how effectively a company is growing its value and managing investors’ money. In simpler terms, it measures the profitability of a company in relation to shareholder's equity.

Check out our latest analysis for Natural Cool 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 Natural Cool Holdings is:

2.5% = S$403k ÷ S$16m (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 SGD1 worth of equity, the company was able to earn SGD0.03 in profit.

Does Natural Cool Holdings Have A Good Return On Equity?

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. If you look at the image below, you can see Natural Cool Holdings has a lower ROE than the average (8.4%) in the Commercial Services industry classification.

roe

That certainly isn't ideal. That being said, a low ROE is not always a bad thing, especially if the company has low leverage as this still leaves room for improvement if the company were to take on more debt. A high debt company having a low ROE is a different story altogether and a risky investment in our books. To know the 5 risks we have identified for Natural Cool Holdings visit our risks dashboard for free.

The Importance Of Debt To Return On Equity

Companies usually need to invest money 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 required for growth will boost returns, but will not impact the shareholders' equity. In this manner the use of debt will boost ROE, even though the core economics of the business stay the same.

Natural Cool Holdings' Debt And Its 2.5% ROE

Natural Cool Holdings does use a high amount of debt to increase returns. It has a debt to equity ratio of 1.71. With a fairly low ROE, and significant use of debt, it's hard to get excited about this business at the moment. Debt does bring extra risk, so it's only really worthwhile when a company generates some decent returns from it.

Summary

Return on equity is one way we can compare its business quality of different companies. A company that can achieve a high return on equity without debt could be considered a high quality business. 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.

Having said that, while ROE is a useful indicator of business quality, you'll have to look at a whole range of factors to determine the right price to buy a stock. 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 I think it may be worth checking this free this detailed graph of past earnings, revenue and cash flow.

Of course, you might find a fantastic investment by looking elsewhere. So take a peek at this free list of interesting companies.

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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.