Return on Equity is a financial metric which denotes the net income a company is earning as per the total value of its outstanding shares. In other words, it signifies the profits a company can generate periodically by employing shareholder’s capital and is computed with the ROE formula.
In this article
What is the Return on Equity Formula?
The formula for calculating the ratio is mentioned below –
ROE = Net Income/Shareholder’s equity
- Net income of an organisation appears in its Income Statement and is the profit a company has earned before it pays out dividends to its shareholders. In most cases, net income realised over the past or trailing 12 months of a company is considered for the ROE calculation formula.
- Shareholder’s equity, on the other hand, is derived by deducting the total value of a company’s liabilities from the total value of its assets. It signifies the amount that is left for shareholders if a company can settle all its liabilities – current and non-current – with its assets.
- Financial analysts also use Free Cash Flow or FCF instead of Net Income in the Return on Equity formula. FCF also signifies a company’s profitability like Net Income; but unlike net income, it does not account for non-cash expenses in the Profit & Loss Account. Instead, it includes expenditures such as changes in working capital as well as spending on company assets and equipment.
However, net income most accurately signifies the organisational and financial efficiency of a company to earn profits by using shareholder’s equity.
Calculation of Return on Equity using ROE Formula
- Computation of shareholder’s equity
The first step in the calculation of Return on Equity is the computation of the shareholder’s equity of an organisation.
Formula: Shareholder’s equity = Total Assets – Total Liabilities
Consider the following example:
In the Balance Sheet of Company A, the following assets are mentioned.
Particulars | Amount (Rs.) |
Land & Building | 5,00,000 |
Machinery | 2,50,000 |
Debtors | 60,000 |
Inventories | 40,000 |
Cash and cash equivalent | 50,000 |
Total Assets | 9,00,000 |
The following liabilities are mentioned in its Balance Sheet.
Particulars | Amount (Rs.) |
Debentures | 4,00,000 |
Creditors | 40,000 |
Outstanding expenses | 60,000 |
Total Liabilities | 5,00,000 |
Therefore, Shareholder’s equity of Company A would be Rs. 4,00,000, i.e. Rs. 9,00,000 – Rs. 5,00,000.
- Calculation of Net Income
Next, an analyst needs to calculate the net income of a company from its annual financial reports. In case an individual is calculating the quarterly ROE, he/she shall consider the profit an organisation has generated in the trailing or previous 3 months from its interim financial reports.
Formula: Total revenue – Total expenses
Net income is derived from the Income Statement of a company and is the difference between the entries on the credit side of a Profit & Loss Account and its debit side.
Considering the above example of Company A, its Income Statement constitutes the following items: Sales – Rs. 7,00,000; interest income – Rs. 50,000; salaries & wages – Rs. 3,50,000; internet and telephone – Rs. 15000; advertising costs – Rs. 30,000; electricity – Rs. 50,000; miscellaneous expenses – Rs. 5000; depreciation – Rs. 25000.
The calculation of net income is given below.
Particulars | Amount (Rs.) | Amount (Rs.) |
Sales | 5,00,000 | |
Interest income | 30,000 | |
Total income | 5,30,000 | |
Salaries & wages | 3,50,000 | |
Internet and telephone | 15,000 | |
Advertising costs | 30,000 | |
Electricity | 50,000 | |
Depreciation | 25,000 | |
Miscellaneous expenses | 5000 | |
Total expenses | (4,75,000) | |
Net Income | 55,000 |
- Computation of Return on Equity
After reckoning the shareholder’s equity and net income of an organisation, an individual has to substitute the variables in the ROE formula with the computed values to compute the Return of Equity ratio of an organisation.
Continuing the above ROE formula example of Company A, its net income is Rs. 2.75 Lakh and its shareholder’s equity is Rs. 4 Lakh.
Therefore, ROE = [(55,000/4,00,000) * 100]
Or, Return on Equity = 13.75%
What is the Significance of the ROE formula and Return on Equity?
The Return on Equity calculation formula throws light on a company’s financial and organisational competency through the profits it generates. It is, therefore, regarded and studied by analysts and investors alike before investing in the stocks of a company. Its importance is mentioned below.
- Sound financial framework
ROE is a crucial financial metric, which provides valuable and quantifiable insight into a company’s financial and organisational foundation as well as its framework.
If a company boasts of a high ROE, it signifies that such an organisation has a sound fiscal model which allows it to generate higher profits or returns with respect to its shareholder’s equity. Hence, investors can bank on such companies to realise substantial dividends and gains.
Considering the above example, an ROE ratio of 13.75% denotes that Company A was able to generate Rs. 0.1375 for every rupee of shareholder’s equity.
- Analysis of the company’s financial growth
Computing using the ROE formula can also provide substantial information about a company’s historical growth over the years. A study of its past ROEs and their comparison with its current one would allow investors and analysts to determine a company’s growth trajectory over the years and how efficient it has been in managing its operations as well as earning profits. Comparison of a company’s financial records can either be done on a yearly or a quarterly basis.
- Comparison with peer companies
One of the most vital usages of this ratio is that it can be used by investors and analysts to compare an organisation’s financial performance with its peers in the industry to which it belongs.
This comparison of this ratio for different companies in the same industry contrasts their financial and organisational competency.
It is essential to note that a comparison between companies from different industries might not provide an accurate representation of an organisation’s fiscal and organisational framework. For instance, the average ratio in the banking industry is usually lower than in the tech industry.
Hence, if a company from the banking industry is demonstrating a 7.5% ROE and a tech company is showing a ratio of 15%, when the average ratios of the banking industry and tech industry is 6.5% and 18% respectively, then it can be construed that such banking company is performing better in comparison to its peers than the tech company.
Therefore, no single Return on Equity ratio can be deemed particularly as good or bad, but multiple ratios for each industry represent the complete scenario. At the same time, it shall be factored in that there might be subcategories within an industry where the average ratio might also vary.
- Determination of growth rates of a company
ROE formula can also be used to determine the growth rate of a company. Although such determination might not be accurate, it can provide a rough idea about the profits a company can generate in the future based on how it has performed in the past. Additionally, it can also be used to estimate the growth rate of a company’s stocks and dividends.
- Recognition of financial discrepancies
ROE is a crucial indicator of fiscal inconsistencies in an organisation. Usually, it is considered that a company with a high Return on Equity ratio is more competent than its peers. However, an excessively high ROE might indicate discrepancies that artificially inflate the ratio when there is no actual prospect.
For instance, in a company that has incurred losses over a few years, its shareholder’s equity will be low. Hence,in a particular year, if a company realises even a minor profit, its ROE would be high.
Another instance is when a company is more reliant on debts than equity, which causes its shareholder’s equity to dwindle and resultantly, when put in an ROE formula with a minor profit will show a high return
What are the Limitations of ROE?
Although financial discrepancies can be found out using the ROE formula and ratios, it also poses a limitation of the ratio. It is because investors cannot rely on the ROE ratio entirely, as it can be inflated for multiple reasons such as mentioned above.
ROE Formula and Other Related Ratios
Investors and analysts use other relevant metrics in tandem with ROE ratio to assess companies before making an investment decision.
- Retention ratio
Retention ratio refers to the percentage of funds a company retains out of its net income. When two companies belonging to the same industry demonstrate similar ROEs, it can be multiplied with the retention ratio to determine the sustainable growth rate of a company.
- Payout ratio
A payout ratio is the percentage of dividend a company dispenses out of its net income to its shareholders. The dividend growth rate of a company can be determined by multiplying the ROE ratio with the payout ratio of a company. It is particularly useful when comparing different companies, especially organisations with kindred Return on Equity ratios.
Other financial metrics can also be used along with ROE to assess a company’s financial standing, such as Return on Operating Capital (ROOC), Return on Capital Employed (ROCE), and Return on Invested Capital (ROIC).