LONDON -- Before I decide whether to buy a company's shares, I always like to look at two core financial ratios -- return on equity and net gearing.

These two ratios provide an indication of how successful a company is at generating profits using shareholders' funds and debt, and they have a strong influence on dividend payments and share-price growth.

Today, I'm going to take a look at global drinks firm Diageo (LSE: DGE) (NYSE: DEO), to see how attractive it looks on these two measures.

Return on equity
The return a company generates on its shareholders' funds is known as return on equity, or ROE. ROE can be calculated by dividing a company's annual earnings by its equity (i.e., the difference between its total assets and its total liabilities) and is expressed as a percentage.

Over the last five years, Diageo's share price has doubled, and its dividend has risen by 26%. Let's take a look at Diageo's ROE for this period:

Diageo

2008

2009

2010

2011

2012

Average

ROE

40%

48.3%

45.9%

41.1%

36.1%

42.3%

Diageo's ROE is highly impressive, but these figures are so high that my first suspicion is that Diageo must be using a lot of debt to pump up returns -- is this true?

What about debt?
One weakness of ROE is that it doesn't show how much debt a company is using to boost its returns. A good way of assessing a company's debt levels is by looking at its net gearing -- the ratio of net debt to equity.

In the table below, I've compared net gearing and ROE for Diageo and two of its peers,SABMiller and Beam. The differences may surprise you:

Company

Net Gearing

5-year
Average ROE

Beam

47%

5%

SABMiller

60%

13%

Diageo

124%

42.3%

Diageo's net gearing is twice that of SABMiller, but the firm's five-year average ROE is 3.25 times that of SABMiller.

However, although Diageo's earnings per share have risen by an impressive average of 9.3% each year over the last five years, SABMiller has achieved a five-year average rate of 8.7% with half the gearing. Given Diageo CEO Paul Walsh's imminent departure, I'm concerned that Diageo's growth may be about to slow.

Is Diageo a buy?
Diageo is currently quite richly priced, with a P/E of 19 and a dividend yield of just 2.3%.

For existing investors, it may be a hold, but for new buyers, I'm not sure that now is a good time to buy. Personally, I plan to wait until Diageo looks a little cheaper or offers a more attractive yield.

Finding market-beating returns
Finding shares that can beat the market over a long period is hard, but if you already own Diageo, then you might be interested in learning about five-star shares that have been identified by the Fool's team of analysts as "5 Shares to Retire On."

I own three of the shares featured in this free report, and I don't mind admitting they are among the most successful investments I've made.

To find out the identity of these five companies, click here to download your copy of this free report now, while it's still available.

link

Roland Head does not own shares of any of the companies mentioned in this article. The Motley Fool recommends Beam and Diageo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.