What is Return on Equity Ratio?
The Return on Equity (ROE) ratio is a profitability ratio used for measuring the return that an organization earns on Shareholders’ Equity. Since Shareholders Equity is equal to Assets – Debt, it can also be considered as the return earned on Net Assets. It is a mixed ratio, which means it uses one element from the Income Statement and the other from the Balance Sheet.
Return on Equity Ratio Formula
The formula for ROE Ratio is:
In essence, The Net Profit that the organization earns for every unit of Shareholders Equity.
Example of Return on Equity Ratio (ROE)
Let’s take an example of the return on equity ratio:
Following is a simple balance sheet of a company.
The net income for the year is given to be $25,000.
The ROE can be calculated as:
- Return on Equity Ratio (ROE) Formula = 25,000/250000
- ROE = 0.10 or 10%
This means that the company has earned a 10% return on shareholders’ equity. This implies that for every $100 of equity, the company has generated an income of $10.
Dupont Return on Equity (ROE) Ratio Analysis
ROE can be decomposed into five components with each component representing an important aspect of the company. This helps in analyzing the exact reason for low or high ROE. ROE can be decomposed into:
This is one of the most important decompositions for analyzing the efficiency of a company.
Advantages of Return on Equity (ROE) Ratio
The following are the advantages of the return on equity ratio.
- #1 – Measuring Efficiency – The ROE ratio is very helpful for the shareholders for measuring the efficiency of the managers. A higher ratio indicates that the managers of the company are efficiently utilizing the shareholders’ money and it gives them a basis to decide to stay invested in the company or leave the company.
- #2 – Easy Calculation – The ratio is fairly simple to calculate and the inputs required are easily available from the financials of the company. The ratio can be calculated directly by using those inputs and feeding them into the formula. Companies usually publish quarterly reports, therefore we can calculate the data for any period we want.
- #3 – Easy Comparison – The ROE ratio helps in eliminating the size differences when comparing the results of companies. Since it is a percentage expressed ratio, we can analyze how each company is performing based on the equity capital available to them.
- #4 – Based on Historical Data – The ROE ratio is based on the historical data of the company. In other words, it is a measured ex-post. We do not need to make any assumptions regarding it. Therefore it is free from the changes arising with a change in an assumption.
The following are the limitations of the return on equity ratio.
- Not Ideal for Start-Ups – Since the ROE ratio takes Net Income as one of the inputs, it is not ideal for start-ups and early-stage companies because they usually have large outflows for research and development purposes. The ROE ratio might paint a bad picture of the company even though it might have high revenue and cash flows, which would indicate growth potential in the mature stages of the company.
- Ignores Leverage – The ROE ratio measures the income generated per unit of shareholders’ equity. It completely ignores the Debt of the company. A company may have high debt obligations which put it in a risky spot but the ROE ration may paint a rosy picture. An alternate for the ROE because of this limitation is the Return on Capital Employed ratio, which measures the income generated per unit of total capital (debt + equity).
- Manipulations – ROE ratio can be easily manipulated by decreasing the number of shares outstanding. Inefficient managers might try to cover up lower ROE by buying back the shares of the company. This would result in a higher ROE ratio even though the Net Income remains unchanged.
- Sensitive to Accounting Practices – Companies use different accounting practices with regard to depreciation (straight line vs accelerated), assets (including intangibles or not), etc. while preparing their financial statements. This would result in data that doesn’t allow comparison among companies. Analysts have to make adjustments to the accounting statements in order to make the data comparable.
Interpretation of Return on Equity (ROE) Ratio
- A higher ROE indicates that the managers are using the capital efficiently and as far as the shareholders are concerned, they are happy to see a high ROE ratio.
- A lower ROE causes the investors to worry and they might pull their capital out of the company if bad results persist. This is the main reason that managers start manipulating the ratio, to keep investors happy.
- A negative ROE could mean that managers are not adequate for handling the company and call for a change in the company structure.
ROE is a widely used performance measure. It is most commonly used by equity analysts who are trying to predict the performance of a company. It is also very commonly used by investors who are looking to invest their money. ROE provides an objective view of how well the managers can handle their money and how much return they can expect. Investors analyze several companies and based on ROE and other performance measures, they take a decision about where to invest their money. Managers try to keep this ratio high for retaining the existing investors and attracting new investors.
This has been a guide to Return on Equity Ratio. Here we discuss the formula of ROE ratio along with examples, advantages, limitations, and interpretations. You can learn more about accounting from following articles –