Return On Equity (ROE)
Return on equity (ROE) is the amount of net income returned as a percentage of shareholders equity. It reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet. Shareholder equity is the portion of a company's total capital that is held by its shareholders. It represents the residual interest in the assets of an entity after deducting liabilities.
ROE is one of the most important financial ratios and profitability metrics. It is often said to be the ultimate ratio or the ‘mother of all ratios’ that can be obtained from a company’s financial statement. It measures how profitable a company is for the owner of the investment, and how profitably a company uses its equity.
ROE Calculation (formula)
Return on equity is calculated by taking a year’s worth of earnings and dividing them by the average shareholder equity for that year, and is expressed as a percentage:
Instead of net income, comprehensive income can be used in the formula's numerator (see statement of comprehensive income).
Return on equity may also be calculated by dividing net income by the average shareholders' equity; it is more accurate to calculate the ratio this way:
ROE = Net income after tax / Average shareholder's equity
Average shareholders' equity is calculated by adding the shareholders' equity at the beginning of a period to the shareholders' equity at the period's end and dividing the result by two.
The ROE formula with average equity in the denominator is considered more precise. This is because average equity takes into account changes in equity over time, providing a better representation of the company's financial performance. On the other hand, using only the current equity in the denominator does not consider changes over time and may lead to a skewed ROE calculation.
A common way to break down ROE into three important components is the DuPont formula, also known as the Strategic Profit model. Splitting the return on equity into three parts makes it easier to understand the changes in ROE over time:
ROE (DuPont formula) = (Net profit / Revenue) * (Revenue / Total assets) * (Total assets / Shareholder's equity) = Net profit margin * Asset Turnover * Financial leverage
Norms and Limits
Historically, the average ROE has been around 10% to 12%, at least in the US and UK. For stable economics, ROEs more than 12-15% are considered desirable. But the ratio strongly depends on many factors such as industry, economic environment (inflation, macroeconomic risks, etc.). Some industries and companies may have a much higher ROE, while others may have a lower one. Additionally, the average ROE can be influenced by various economic and market factors.
The higher the ROE, the better. But a higher ROE does not necessarily mean better financial performance of the company. As shown above, in the DuPont formula, the higher ROE can be the result of high financial leverage, but too high financial leverage is dangerous for a company's solvency.
ROE can be negative. It occurs when a company's net loss is greater than its shareholders' equity, indicating that the company is not generating enough revenue to cover its costs and meet its financial obligations. A negative ROE is a sign of financial distress and can indicate that the company is facing financial challenges.
Exact Formula in ReadyRatios Analysis Software
ROE (net profit version) = F2[ProfitLoss]*(365/NUM_DAYS)/((F1[b][Equity] + F1[e][Equity])/2)
ROE (comprehensive income version) = F2[ComprehensiveIncome]*(365/NUM_DAYS)/((F1[b][Equity] + F1[e][Equity])/2)
F2 – Statement of comprehensive income (IFRS).
F1[b], F1[e] - Statement of financial position (at the [b]egining and at the [e]nd of the analysed period).
NUM_DAYS – Number of days in the the analysed period.
365 – Days in year.
Industry benchmark
There is our industry benchmarking calculated using US SEC data, where you can find average values for ROE ratios.
Return on Assets (ROA) ratio is similar to the Return on Equity (ROE) ratio but measures the profitability of a company's assets, while ROE measures the profitability of a company's equity. Both ratios are commonly used to evaluate a company's financial performance and efficiency in generating profits from its investments.
How to Improve ROE?
A company can improve its return on equity (ROE) by taking the following actions:
- Increasing profitability: A company can increase its net income, which is the numerator in the ROE formula, by improving its revenue, reducing its costs, or both.
- Reducing debt: If a company has high debt levels, it may reduce its ROE by increasing its interest expenses. By reducing its debt, a company can reduce its interest expenses, improve its ROE, and reduce its financial risk.
- Increasing shareholder equity: A company can increase its ROE by increasing the denominator in the formula, shareholder equity. This can be done by retaining earnings instead of paying dividends, issuing new stock, or reducing liabilities.
- Improving operational efficiency: By streamlining operations and reducing waste, a company can improve its profitability, which in turn can improve its ROE.
- Increasing revenue growth: A company can improve its ROE by growing its revenue faster than its expenses, which will increase its net income.
It's worth noting that these actions are not mutually exclusive and that a company can pursue multiple strategies to improve its ROE at the same time.
Disadvantages of Using ROE
ROE is an extremely useful financial indicator, but it also has a number of disadvantages. The following are some disadvantages:
- Doesn't account for debt financing: ROE only measures the efficiency of equity capital in generating profits, and doesn't consider the impact of debt financing.
- One-year focus: ROE only considers a company's profitability over a one-year period, and may not give a complete picture of a company's long-term performance.
- Reliance on accounting methods: ROE can be affected by a company's choice of accounting methods, and may not provide a completely accurate representation of the company's financial performance.
- Doesn't reflect the risk involved: ROE doesn't reflect the risk involved in generating profits, and a high ROE could be a result of taking on more risk.
- Industry comparison: ROE may not be directly comparable across different industries, as some industries naturally have a higher ROE than others.
Therefore, ROE should not be used as the sole metric for evaluating a company's financial performance and should be used in conjunction with other financial ratios and qualitative information.
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DESMOND
University of Professional Studies, Accra, Ghana