Return on Equity (ROE) is one of the Financial Ratios use to measure and assess the entity’s profitability based on the relationship between net profits over its averaged equity. Two main important elements of this ratio are Net Profits and Shareholders’ Equity.
Return on Equity (ROE) is the ratio that mostly concerns shareholders, management teams, and investors in terms of profitability assessment. It is also commonly used as key financial indicator in performance measurement and setting the KIP for the entity.
However, many accounting technical and investors warn that this ratio could return many risks to the entity if misused.
Return on Equity (ROE) measures the direct profits that the entity could generate from business operations to its shareholders or investors over the invested fund (equity).
It simply means how much profit ($) the entity could generate per ($) invested.
The best way to make this ratio more meaningful is to use other financial indicators and non-financial indicators. Return on Equity (ROE) is said to be good if it is over the cost of capital.
Return on Equity (ROE) = Net Profit / Total Equity
- The equity here is sometimes could be the equity at the end of the period. And sometimes, it could be the equity on average. For fair assessment, the equity should be in averages. That means equity balance at the beginning of the period plus the equity balance at the end of the period divided by two. Yet, if you could not find or they provide only the equity at the end, let use the ending balance. You can also find the equity balance from the balance sheet if you don’t tell you. For example, total equity = total assets less total liabilities. Remember, equity is the net worth, and none of the liabilities is included. It is different from capital employed since capital employed is net worth plus long-term liabilities.
- The Net Income is quite straightforward. We pick up the Net Income that you use for the period that you want to analyze. You can find net income in the income statement in the period you want to assess or calculate it from the balance sheet. However, the period that you analyst must be consistent; otherwise, your analysis will not be fairly interpreted. Remember, the net income you use to calculate ROE must be after deducting taxes and interest expenses.
The first thing that we need to think about to calculate and analyze Return on Equity (ROE) is Net Profit. Net Profit here is the profit after tax that an entity generates for a period of time.
Net profit arrived after deduction many significant importance expenses. Those expenses include Cost of Goods Sold, Operating Expenses, Interest Expenses, and tax expenses.
As you could see, the way how we calculate Net Income above. It is after deduction many significant expenses that the entity could manipulate if they wish to.
For example, depreciation expenses are subject to the entity’s accounting policies. Management could use both accounting techniques and accounting policies to make depreciation expenses increase or decrease as they want to. And subsequently, affect Return on Equity Ratio.
The revenue also could be manipulated. For example, early recognition of Sales Revenue before the period that it should be. See the disadvantage for detail. The second thing is Shareholder Equity. Shareholder Equity here includes all equity items in the Financial Statements.
However, for fairness interpretation, Return on Equity, Average Shareholder Equity should be used. It is calculated by the average of both the beginning and ending of Shareholder Equity of an Entity.
Let do some fact check on the disadvantages of ROE,
- Return on Equity (ROE) is the profitability ratio used by investors and shareholders to assess how profitable the company is compared to others, budget, or expectations. That is why this ratio creates any risks to shareholders whenever it becomes the priority in performance measurement.
- The common reason why it is risky is that this ratio is the financial ratio (figure). The management could manipulate the figure. Management of the company needs to make sure it gets a better result. For example, if this ratio is used as the main key performance indicator for deciding management bonus. Then, management might try to play around with the figure.
- Management may try to manipulate the Return on Equity (ROE) by not investing in the new fixed assets or making proper maintenance. It also keeps using the old assets that significantly affect the operating expenses through depreciation. This ratio could also be manipulated by using the depreciation rate to affect Return on Equity (ROE) positively. All of these will affect the future of the entity.
- Besides disadvantages, this Return on Equity (ROE) also has many advantages. It is easy to calculate and understand by most nonaccounting managers, investors, and shareholders. As we can see, this ratio is straightforward to calculate. All of the information is available in the financial statements, and it is calculated base on a logical basis. Non-accounting managers, investors, and shareholders are also able to confirm the accuracy of this ratio. Right?
- The basis is straightforward to understand by most types of managers. The not only manager who has experience in accounting could easily understand, but operation manager or division managers also easy to use and interpret.
- Most investors and shareholders are bench-marking the ROE from their own companies with the market figure or competitors. Especially the one in the same industry. It provides them with a good starting point to assess their companies’ performance.
High Vs Low Return on Equity
Okay, let think about these questions
- Does Low Return on Equity really the problem?
- Is it always good if the return on equity is high?
Well, the answer is, it depends. Let us explain this.
As we explain above, the relationship between these ratios is mainly based on two important items—net Income and Equity. And to increase this ratio, for sure we need to increase Net Income. But what if the increase in net income is not because of the company performing well.
But because management tries to play around with some accounting policies to make income look better than it should be?
Like the example above, sales revenue might be early recognized, depreciation policies implement inconsistently, using old assets to decrease depreciation expenses.
Another way to manipulate this ratio is to manipulate the equity items. How?
What if management uses external bank loans to buy back or pay the dividend to ensure that the equity balance decreases while the net income for that period is still the same.
The equity ratio will increase, right?
It is a big problem, right?
If investors depend on the return on the equity ratio solely when they consider whether to buy shares or having assessed that the entity is performing well.
So high ROE does not always mean good, and a low ratio does not always mean bad.
Deep analysis and comparison with other financial and non-financial ratios are the mandatory requirements to ensure that investors’ wrong interpretation is being offered to investors.
Now, let’s start with the example to understand better how to use the formula and calculation.
For example, ABC is a company operating in the bank industry. The shareholders are now really concerned about the return on the shares capital that they invested.
Right now, the management team needs the ROE figure with analysis from your finance department.
From 1 January to 31 December 2015, ABC generates USD 3,000,000, and the total equity at the end of the period is USD 70,000,000.
Use the formula above. There we got this:
Return on Equity (ROE) is 3,000,000 / 70,000,000 = 0.042 or 4.2%.
Now let see how the figure tells us. Based on the calculation, ABC got 4.2% of its ROE, and we don’t have the competitor ROE or IRR for ABC.
In general, to make a meaningful assessment, we should know the previous year’s ROE, IRR, and the average ROE in the market ABC being operated.
What is a good return on equity?
It is difficult to answer this question as it is challenging to quantify the percentage that could satisfy the investors.
However, based on the nature of equity is high risks than debt, the higher return on equity compare to debt is considered the good one. For example, if the debenture interest rate is around 5%, then the return on equity around 10% to 15% is quite good.
A good return on equity also depends on the board of directors’ rate, previous year rate, and industry rate.
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Written by Sinra