A business entity runs several financial analyses, ratios, and formulas to get insights into financial health and position. Some analyses are only useful for internal purposes. However, many analyses are equally beneficial for external as well as internal stakeholders of an entity.
Financial ratios are widely used financial analysis that gives useful insights to external stakeholders and internal management. Profitability ratios tell about how well a company is doing in its industry and operational activities. Similarly, the leverage or debt ratios give a glimpse of the company’s utilization of the external debt to earn revenues. Other ratios like liquidity ratios, investment ratios, and return ratios also give useful information for comparison across industries and over time.
Shareholders of a company are the major stakeholders of its activities. The contribution of the shareholders is called equity.
An existing shareholder will be interested in knowing what the company is earning for his share? Is his investment worth it? Similarly, a prospective shareholder will be looking for information on how well a company earns revenues and gives its shareholders returns.
Return on equity is a financial ratio that answers the questions mentioned above of shareholders and stakeholders. This article will go through the return on equity, its formula, uses, and calculation.
What Is Return On Equity?
Return on equity is a financial performance ratio that measures how well a company uses shareholders’ money to grow revenues.
We can formally define return on equity as,
Return on equity measures how effectively a company uses the shareholders’ contribution and retained profits for making more money(profit). More comprehensively, the business entity can turn the capital into revenue.
The shareholder equity is calculated by subtracting all short-term and long-term debt from the company’s total assets. Therefore, the return on equity is often called the return on net assets.
How To Interpret Return On Equity
From the definition of the return on equity, it can be understood that the higher value of RoE is more desirable. When the RoE of a company is higher, it is using its investments and capital productively to grow the shareholders’ assets. On the other hand, a lower return on equity means mismanaged capital or lower reinvestment rates.
Since RoE is a financial performance ratio, the higher ratio is generally better. However, the stakeholders must use caution when assuming a higher return on equity ratio as a better measure. In some cases, the higher ratio might mean that a company’s debt is way higher than the equity. As a result, the amount of shareholder’s equity will be lower. The subsequent lower earnings will give a higher RoE against such shareholders’ equity.
Hence, such an artificial rise can be mischievous. Therefore, return on equity should not be analyzed in isolation. The interpretation of RoE also varies from industry to industry. For instance, some industries might have higher returns on each dollar invested than other industries. Therefore, when assessing RoE, stakeholders should always compare with companies in the same industry.
Formula For Calculating Return On Equity
The return on equity of a business entity can be calculated by the following formula:
Return on Equity = Net Income / Average Shareholder’s Equity
The net income in the formula is the after-tax income of the business entity during a financial period. It is the income stated on the last line of the income statement. The net income used in the formula is before-dividend income. Similarly, the average shareholder’s equity is calculated by subtracting all debt from the company’s total assets.
Calculation Of Return On Equity
The return on equity is represented as a percentage. Let’s understand the calculation of return on equity with an example.
A retail company, Oliver & Co., had total assets of USD 2.5 million. The long-term and short-term debts of the company were totaled at USD 1 million. The net income after tax was USD 250,000. What will be the return on equity?
Return on Equity = Net Income / Average Shareholder’s Equity
And
Average shareholder’s equity = Total Assets – Total Liabilities
Average shareholder’s equity = USD 2.5 million – USD 1 million
Average shareholder’s equity = USD 1.5 million
Return on Equity = 250,000/1,500,000
Return on equity = 0.1667 or 16.67%
The standard RoE in the retail industry for the financial year was 12.5%. Is the value of RoE better or not?
From the above calculation, it is interpreted that Oliver & Co. is doing better in terms of return on equity compared to other companies in the same industry.
Why Is RoE Important Financial Ratio?
Besides giving information about how well the business uses its capital to earn revenues, RoE is an important ratio from other perspectives. Here are some important metrics that can be understood and interpreted with the help of RoE.
Growth Rate Estimation
The return on equity is a very useful measure in growth rate estimation, such as sustainable growth rate and dividend growth rate. The sustainable growth rate is defined as the maximum growth rate a business entity can maintain without having additional investment or capital input(debt or equity). The sustainable growth rate can be increased by improving the revenue and sales without additional capital.
The sustainable growth rate can be calculated as follow:
Sustainable Growth Rate = Return on Equity X Retention Rate
The higher sustainable growth rate indicates that the company uses more profit to invest in growth opportunities. The stakeholders can interpret high sustainable growth as more growth and expansion opportunities in the market. The company will reinvest its profit if the management believes there are growth prospects.
Dividend Growth Rate
Dividend growth represents the payout growth rate of a business entity. The stakeholders can find the DGR with the help of RoE. Investors looking for cash-paying companies are more interested in the higher dividend ratios. However, a high RoE necessarily does not mean the company’s dividend growth rate is also higher.
The dividend growth rate can be calculated as the following formula:
Dividend Growth Rate = Return on Equity X Dividend Payout Rate
Two companies in the same industry with the same return on equity might have a different dividend growth rate. The reason is that one company might have a different retention rate than another.
Leverage Effect
As discussed earlier, the high return on equity might not necessarily mean the company utilizes the share capital to generate revenues. Sometimes the high RoE might be due to the high debt of the business entity. The high income might be generated by utilizing the debt.
However, the RoE does not consider which part of income is generated by debt or share capital. Therefore, the stakeholders should be cautious when analyzing RoE in isolation.
Identification Of Problems
A very high RoE than the industry average is not always a good sign. A higher RoE can be used to identify different financial problems surfacing in the company. For instance, the RoE of a company might be artificially high due to negative income and negative shareholder’s equity during a financial period.
The excess debt can also elevate the RoE artificially. The inconsistent profits can also be a reason behind a high RoE. For instance, if a company had a loss for the past 4 years. It was recorded as a retained loss in the balance sheet. The company made a profit in one year, but the shareholder’s equity has declined. As a result, the company will report higher than normal RoE in that financial year.
DuPont Formula For RoE: Explained
THE DuPont formula can be helped for finding the return on equity. It is basically a framework to assess the fundamental performance of the company. The DuPont corporation developed the DuPont framework and became popular for assessing the financial performance of business entities. The formula for DuPont can be breakdown to find the RoE.
The DuPont formula is as follow:
DuPont Analysis = Net Profit Margin X Asset Turnover X Equity Multiplier
Net Profit Margin = Net Income/ Revenue
Asset Turnover = Sales/ Average Total Assets
Equity Multiplier= Average Total Assets/ Average Shareholder’s Equity
When incorporated the formulas in the DuPont analysis,
From the formula, it can be understood that if the profit margin of a business entity increases over time, the firm’s RoE will also increase. Similarly, the increase in asset turnover ratio means that the firm’s assets bring in the most revenue. With the increased financial leverage of the firm, there is more capital available to increase the return and revenues.
Conclusion
The return on equity measures a business’s efficiency to use the share capital for generating revenues. The financial metric is useful for internal as well external shareholders. It is different from return on an asset in the aspect that the RoE calculates the net income to the net assets of the company. However, the return on assets compares the revenues with the company’s total assets (without subtracting the liabilities).
The stakeholders should analyze the return on equity by comparing other financial metrics too. The combined financial ratio analysis to get useful insights about a company before making investments.
