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What is Return on Equity Ratio?

The Return on Equity (ROE) Ratio is an accounting ratio of a company’s net profit to its total shareholder equity. There are two basic sources of shareholder equity. The money that was originally invested in the company is the first and original source. The second source is retained earnings, which the company can accrue over time as a result of its operations. It basically shows how much profit a company makes for every rupee invested by its shareholders. It’s commonly given as a percentage. Preferred shareholders, an unique type of investor are not included in the ROE calculation. The preference shareholders are guaranteed a fixed dividend payment every year, As a result, it indicates the profitability of the company as earned by ordinary shareholders.

The return on investment (ROI) is computed by dividing net profit by net worth. If a company’s return on investment (ROI) is low, it means the company did not invest shareholder funds efficiently. Hence, higher the return on investment more efficiently is the use of shareholder’s capital.

Return on Equity Ratio Formula

The formula for the Return on Equity Ratio is:

Return on Equity (ROE) Ratio = Net Income / Shareholder’s Equity

Where,

Net Income = Total Revenue – Cost of Goods Sold- Operating Expenses- Interest Payable – Taxes

Shareholder’s Equity = Total Assets – Total Liabilities  or Share Capital + Retained Earnings + Other Reserves

Total Assets = Tangible Assets + Intangible Assets

How to Calculate Return on Equity (ROE) Ratio?

The following illustration demonstrates how to calculate the Return on Equity (ROE) Ratio:

ParticularsCompany-AAmountCompany-BAmount
Tangible AssetsRs 23,00,000Rs 20,00,000
Intangible AssetsRs 8,00,000Rs 8,00,000
Short Term LiabilitiesRs 9,00,000Rs 7,00,000
Long Term LiabilitiesRs 10,00,000Rs 9,00,000
Total RevenueRs 17,00,000Rs 13,00,000
Cost of Goods SoldRs 9,00,000Rs 8,00,000
Operating ExpensesRs 3,00,000Rs 3,00,000
Interest PayableRs 1,00,000Rs 2,00,000
Tax PayableRs 1,50,000Rs 1,00,000
Total Assets
(Tangible Assets + Intangible Assets)
Rs 31,00,000
(Rs 23,00,000 + Rs 8,00,000)
Rs 28,00,000
(Rs 20,00,000 + Rs 8,00,000)
Total Liabilities
(Short Term Liabilities + Long Term Liabilities)
Rs 19,00,000
(Rs 9,00,000 + Rs 10,00,000)
Rs 16,00,000
(Rs 7,00,000 + Rs 9,00,000)
Total Equity
(Total Assets – Total Liabilities)
Rs 12,00,000
(Rs 31,00,000 – Rs 19,00,000)
Rs 12,00,000
(Rs 28,00,000 – Rs 16,00,000)
Net Income
(Total Revenue – Cost of Goods Sold- Operating Expenses- Interest Payable – Taxes)
Rs 2,50,000
(Rs 17,00,000 – Rs 9,00,000 – Rs 3,00,000 – Rs 1,00,000 – Rs 1,50,000)
(Rs 1,00,000) Loss
(Rs 13,00,000 – Rs 8,00,000 – Rs 3,00,000 – Rs 2,00,000 – Rs 1,00,000)
Return on Equity (ROE) Ratio
(Net Income / Shareholder’s Equity)
20.83%
(Rs 2,50,000 / Rs 12,00,000)
(8.33%) Negative ROE
[(Rs 2,50,000) / Rs 12,00,000]
Company A has earned a 20.83% on the Rs 12,00,000 capital invested.
A positive and higher ROE demonstrates an efficient use of shareholder’s equity. 
For the same shareholder’s equity, Company B has a negative ROE of 8.33%.
The negative ROE is due to the losses earned. Further analysis with other ratios will help understand the financial health and potential.

Importance of Return on Equity (ROE) Ratio

Investors must comprehend the reasons for the company’s expansion as well as other aspects that aid in its profitability. This is why financial experts look at other metrics. The ROE provides insight into how the company utilizes its capital assets. Financial experts must understand whether the capital is being used effectively or not.  This is critical for investors. Companies that make good financial decisions go a long way. Even in difficult circumstances, they have a better chance of success. Because investors profit when a company succeeds, ROE can be a useful metric.

Before making any investment decisions an investor must learn evaluation and comparison of the ROE of several companies. It’s also a good idea to look at the company’s ROE patterns over time.

For investment decisions, a financial analyst should not rely entirely on ROE. Because it can be manipulated artificially by management, it is not the most dependable of parameters. When debt financing is utilised to reduce share capital the ROE increases even though income remains constant.

Interpretation of Return on Equity (ROE) Ratio

Unlike other return on investment ratios, ROE measures profitability from the perspective of the investor. To look at it another way, this ratio determines how much money is made based on the investors’ investment in the company rather than the company’s investment in assets.

Higher Return on Equity (ROE) Ratio

A higher ROE means that the company generates higher earnings with the same amount of resources. Companies do not often issue new shares. Hence, the only variable is profit. This profit or earnings is determined by the company’s income and expenses. As a result, a rising ROE indicates that the company is earning more with the same amount of capital. This indicates that the capital is being used effectively. As a result, looking at the ROE might provide insight about the company’s growth potential.

Companies with a high return on investment are better at retaining earnings. Any business can use retained earnings as a source of capital. When a company retains its earnings and reinvests them as working capital, the need for debt diminishes. This leads to free of interest costs for the company. Every year an investor should look at the company’s retained earnings and its return on equity. If the company is profitable and the ROE is rising, this indicates that the company is producing revenue from the retained earnings.

Companies with a high return on investment (ROI) have an edge over their competitors. They can easily protect their long-term earnings and control their market share. Such businesses can earn long-term profits and reinvest profits to maintain cash flow.

Negative Return on Equity (ROE) Ratio

A company’s return on investment (ROI) might be in the negative figures. However, during periods of positive net income returns, the company may have negative shareholder equity due to liabilities exceeding assets. In such a circumstance, the ROE calculated using the formula will be negative.

It’s important to remember that a low ROE doesn’t necessarily mean the company is doomed. However, it should serve as a warning to proceed with extreme caution. In most cases, a negative ROE indicates that the organization is having issues with debt, asset retention, or both.

Limitations

  • Investors should consider ROE in connection to other indicators, just like any other indicator. To begin with, ROE can be positive even when earnings and shareholder equity are down. As a result, an analyst must compare ROE to the company’s profits. 
  • Furthermore, when the value of shareholder stock diminishes, ROE rises. When a company’s liabilities and debt grow, or when the company buys back its own shares, this can happen. In actuality, this is a disadvantage. 
  • A company that depends too much on debt to boost shareholder returns may find itself in financial problems. This is a significant issue in highly competitive businesses where market share can change.  
  • Owing to inconsistent cash flow a company may find it difficult to make loan payments on time. However, an investor could be misled by the increased ROE. As a result, the ROE cannot be assessed on its own.