Should Sulzer Ltd (VTX: SUN) focus on improving this fundamental metric?

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One of the best investments we can make is in our own knowledge and skills. With that in mind, this article will discuss how we can use Return on Equity (ROE) to better understand a business. As a learning-by-doing, we’ll take a look at the ROE to better understand Sulzer Ltd (VTX: SUN).

ROE or return on equity is a useful tool to assess how effectively a company can generate the returns on investment it has received from its shareholders. In simpler terms, it measures a company’s profitability relative to equity.

Check out our latest review for Sulzer

How is the ROE calculated?

The return on equity formula is:

Return on equity = Net income (from continuing operations) ÷ Equity

So, based on the above formula, Sulzer’s ROE is:

6.2% = CHF 87 million ÷ CHF 1.4 billion (based on the last twelve months up to December 2020).

The “return” is the amount earned after tax over the past twelve months. This means that for every CHF 1 of equity, the company generated CHF 0.06 in profit.

Does Sulzer have a good return on equity?

Perhaps the easiest way to assess a company’s ROE is to compare it to the industry average. It is important to note that this measure is far from perfect, as companies differ considerably within a single industry classification. As shown in the image below, Sulzer has a lower ROE than the machinery industry average (10%).

SWX: SUN Return on Equity August 23, 2021

Unfortunately, this is suboptimal. However, a low ROE is not always bad. If the company’s debt levels are moderate to low, there is still a chance that returns can be improved through the use of financial leverage. A highly leveraged business with a low ROE is a whole different story and a risky investment on our books. You can see the 4 risks we have identified for Sulzer by visiting our risk dashboard for free on our platform here.

What is the impact of debt on return on equity?

Almost all businesses need money to invest in the business, to increase their profits. This liquidity can come from retained earnings, the issuance of new shares (shares) or debt. 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 will not affect total equity. This will make the ROE better than if no debt was used.

Sulzer’s debt and its ROE of 6.2%

Noteworthy is Sulzer’s high reliance on debt, leading to its debt-to-equity ratio of 1.23. The combination of a rather low ROE and a high recourse to debt is not particularly attractive. Debt brings additional risk, so it’s only really worth it when a business is making decent returns from it.

Conclusion

Return on equity is useful for comparing the quality of different companies. Firms that can earn high returns on equity without taking on too much debt are generally of good quality. All other things being equal, a higher ROE is better.

But when a company is of high quality, the market often offers it up to a price that reflects that. Especially important to consider are the growth rates of earnings, relative to expectations reflected in the stock price. You might want to take a look at this data-rich interactive chart of the forecast for the business.

Sure Sulzer may not be the best stock to buy. So you might want to see this free collection of other companies with high ROE and low leverage.

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