Return on Equity (ROE) is ratio between Net Profit Before Interest and TAX. and Equity. It compares Net Profit Before Interest and TAX with Equity. Equity is Share Capital plus Retained Profit – all the money that has been invested in the business by the owners.
What does Return on Equity (ROE) measure?
The Return on Equity (ROE) shows Net Profit Before Interest and TAX as a percentage of Equity. This ratio tells us how much Net Profit Before Interest and TAX is earned for every USD$1 of Equity of the business.
Return on Equity (ROE) shows Net Profit After Interest and TAX as a percentage of all the internal capital used to generate it. Return on Capital Employed (ROCE) measures how well a firm’s own financial resources are being used – only internal sources of finance.
Return on Equity (ROE) measures the financial performance of a firm compared with the amount of internal capital invested. Specifically, effective management of shareholders’ capital as this ratio shows shareholders the returns the company provides for every USD$1 they invest. The business’s own money is used to purchase profit earning assets such as buildings and machinery.
Equity can be seen on a firm’s Balance Sheet. Equity is the total value of all long-term finance invested in the business without any long-term debt. Equity is the owners’ equity (or shareholders’ funds) including Share Capital and Retained Profit. It is the sum of total internal sources of finance.
Return on Equity (ROE) measures how well the business’s managers are using shareholders’ capital which is the firm’s own financial resources. And, how wisely the business is reinvesting its own earnings.
How to calculate Return on Equity (ROE)?
The figures for working out Return on Equity (ROE) can be found in Profit and Loss Account (P&L Account) and Balance Sheet:
| Net Profit Before Interest and TAX | |||
| Return on Equity (ROE) = | ━━━━━━━━━━━━━━━━━━━━ | x 100 | |
| Equity |
In this case:
Equity = Share Capital + Retained Profit
Return on Equity (ROE) is calculated by using Net Profit Before Interest and TAX as this allows for better historical comparisons. It is because interest rates and TAX rates are subject to change over time, and are beyond the control of the business and its managers.
Comment
Return on Equity (ROE) is expressed as a percentage.
If a business has Net Profit Before Interest and TAX of USD$500,000 and Equity of USD$1,000,000, then Return on Equity (ROE) is 50%. If Return on Equity (ROE) is 50%, it means that for every USD$100 of Shareholder’s Equity of the business, USD$50 of Net Profit Before Interest and TAX is generated.
Return on Equity (ROE) is of little use unless it is compared with the business’s results from previous years and with results of similar businesses in the same industry. Managers should compare Return on Equity (ROE)with other businesses in the same industry. As a general rule, if Return on Equity (ROE) increases from one year to the next, or the business has a higher Return on Equity (ROE) than competitors, the business’s profitability has improved, or is better than similar firms in the industry.
Return on Equity (ROE) should be above 20%.
Of course, the higher Return on Equity (ROE), the better for the business. By comparing a company’s Return on Equity (ROE) to the industry’s average, this ratio may provide insight into how the company management is using financing from Equity to grow the business. A sustainable and increasing Return on Equity (ROE) over time can mean a company is good at reinvesting its own earnings wisely as well as the shareholder’s money, so as to increase productivity and profits. In contrast, a declining Return on Equity (ROE) can mean that management is making poor decisions on reinvesting own capital in unproductive assets.
Return on Return on Equity (ROE) must consider risk return. Shareholders will compare Return on Equity (ROE) with the possible return, if the capital was invested elsewhere. Return on Equity (ROE) should at least exceed the interest rate offered at banks. Otherwise, it would be better to simply deposit the capital in an interest-bearing bank account. In addition, bank deposits would probably carry less risk compared with staying invested in the business. Hence, Return on Equity (ROE) must be high enough to create an incentive for investors to keep their money invested in the business.
When Return on Equity (ROE) is higher than Return on Capital Employed (ROCE), it means that the return a company generates on capital owned by shareholders (investors) is higher than the return a company generates on capital owned by lenders. It is good for shareholders (investors), but not good for lenders.
Example for Return on Equity (ROE)
COMPANY A
Company A has Sales Revenue of USD$1,000,000, Cost of Goods Sold (COGS) of USD$700,000, Gross Profit of USD$300,000, Expenses (Overheads) of USD$150,000 and Net Profit Before Interest and TAX of USD$150,000 in 2020. One year later in 2021, Company A has Sales Revenue of USD$1,500,000, Cost of Goods Sold (COGS) of USD$600,000, Gross Profit of USD$900,000, Expenses (Overheads) of USD$100,000, and Net Profit Before Interest and TAX of USD$800,000.
The Capital Employed of this business has been USD$1,500,000 in both 2020 and remained unchanged in 2021. Capital Employed of Company A includes both Long-term Liabilities (Long-term Bank Loans and Debentures) which amount to USD$500,000 as well as Equity (Share Capital and Retained Profit) which amount to USD$1,000,000.
| 2020 | 2021 | ||||||
|---|---|---|---|---|---|---|---|
| Sales Revenue | $1,000,000 | $1,500,000 | |||||
| Cost of Goods Sold (COGS) | $700,000 | $600,000 | |||||
| Gross Profit | $300,000 | $900,000 | |||||
| Expenses (Overheads) | $150,000 | $100,000 | |||||
| Net Profit Before Interest and TAX | $150,000 | $800,000 | |||||
| Equity | $1,000,000 | $1,000,000 | |||||
| Equity = Share Capital + Retained Profit | |||||||
| Return on Equity (ROE) | 15% | ➚ | 80% |
What happened? In 2020, Company A has Net Profit Before Interest and TAX of USD$150,000 and Equity of USD$1,000,000. This gives us Return on Equity (ROE) of 15%. If Return on Equity (ROE) is 15%, it means that for every USD$100 of shareholders’ capital invested in the business, USD$15 of Net Profit Before Interest and TAX is generated. However, in 2021, Company A has Net Profit Before Interest and TAX of USD$800,000 and Equity of USD$1,000,000. This gives us Return on Equity (ROE) of 80%. If Return on Equity (ROE) is 80%, it means that for every USD$100 of shareholders’ capital invested in the business, USD$80 of Net Profit Before Interest and TAX is generated.
Why it happened? It happened because Net Profit Before Interest and TAX increased from $150,000 in 2020 to $800,000 in 2021. Higher Net Profit Before Interest and TAX was the result of higher Sales Revenue, lower cost of production Cost of Goods Sold (COGS) and lower Expenses (Overheads).
What does the change mean? Company A’s Return on Equity (ROE) is higher as the company managed to increase its revenue using the same Equity, meaning that the business’s profitability has improved. The management of Company A was more effective using firm’s own money to grow the business.
Is it good or bad for the business? This is good for Company A as a sustainable and increasing Return on Equity (ROE) over time can mean that a company is good at investing its own internal financing (reinvesting its Retained Profit), so as to increase productivity and profits. The management of Company A is more effective at making the shareholders’ money invested in the business earn profit. The higher the value of this ratio, the greater the return on the capital invested in the business by the owners.
How to improve Return on Equity (ROE)?
Return on Equity (ROE) measures how well a firm is able to generate profit from its own sources of funds. Return on Equity (ROE) can be improved mainly by strategies to boost Net Profit Before Interest and TAX. Mathematically, Return on Equity (ROE) will also increase when shareholder’s equity falls whilst Net Profit Before Interest and TAX remains constant, although in reality this is probably not desirable.
Possible strategies to increase Return on Equity (ROE) include:
1. Increase Net Profit Before Interest and TAX:
This should be done without increasing Equity. Meaning, without selling new shares to raise money nor without retaining new profit. So, how to do that then?
- Increase Sales Revenue. This should be done by maintaining the profitable and efficient use of the assets owned by the business, and building new revenue streams.
- Increase profit margins. Lower the cost of production Cost of Goods Sold (COGS) to increase Gross Profit Margin (GPM) ratio and lower Expenses (Overheads) to increase Net Profit Margin (NPM) ratio. You can also close down unprofitable business centers to eliminate inefficient costs.
- Lower TAXes. In general, the lower the TAX rate, the higher the profits (if all else equal).
2. Reduce Equity:
This should be done by generating the same Net Profit Before Interest and TAX, but using less Equity. So, how to do that then?
- Use cash to buy back shares. By buying shares from the owners, the business will reduce Total Assets, hence reduce Equity without impacting the business’s productive capacities.
- Use more debt capital. By increasing the amount of long-term financial leverage relative to its equity capital, a business will increase Long-term Liabilities, hence can reduce Equity. In general, Long-term Liabilities increase a business’s Return on Equity (ROE) as long as the cost of debt (Interest payments in Profit and Loss Account (P&L Account)) is lower than its return on equity.
- Improve inventory control. This should be done by holding less inventory which will improve asset turnover. When the company has poor inventory control, it will carry more inventory than it can use. With holding lower inventory, the business uses fewer Total Assets to generate the same amount of Sales Revenue.
- Pay out a dividend. This should be done by distributing idle cash to shareholders in the form of paying out more dividends monthly, quarterly or annually. This will reduce Total Assets (Cash under Current Assets) and increase Total Liabilities (Dividend under Current Liabilities), hence reduce Equity.
