Investors usually evaluate their investments in companies by measuring their profitability. For that, these investors may use profitability ratios. Among the various profitability ratios that they can use, the Return on Equity is one of the most common ones.
What is the Return on Equity ratio?
The Return on Equity (ROE) ratio is a metric that provides investors with insight into a company’s efficiency. It compares a company’s returns or net income with its total shareholders’ equity. The result comes in the form of a percentage. The ROE ratio indicates how the company’s management handles the shareholders’ money to make profits.
Investors prefer to invest in companies with a high ROE ratio. It is because a high ROE ratio indicates the company’s efficiency in generating profits. On the other hand, a low ROE ratio may indicate a poor performance from the company’s management. However, investors must use the ROE ratio comparatively rather than on its own.
How to calculate the Return on Equity Ratio?
There are various methods of calculating a company’s ROE ratio. However, the most straightforward ROE formula is as follows.
Return on Equity = Net Income / Total Shareholder’s Equity x 100
In the above formula, net income represents a company’s net profits available in its Income Statement. Similarly, total shareholders’ equity represents the company’s total funds obtained from its shareholders. It may consist of paid-in and additional paid-in capital along with retaining earnings. The figure is available in a company’s Balance Sheet.
Another method used to calculate the ROE ratio is through a company’s Return on Assets and leverage ratios. Therefore, the formula for the ROE ratio can also be as follows.
Return on Equity = Return on Assets x Leverage
Investors can use any of the above to ROE formulas to calculate the ratio based on the available information. Either way, they will produce the same result.
Example
A company, Blue Co., generated a net income of $100,000. The company’s total shareholders’ equity on its Balance Sheet at the year-end was $400,000. Therefore, Blue Co.’s ROE ratio will be as follows.
Return on Equity = Net Income / Total Shareholder’s Equity x 100
Return on Equity = $100,000 / $400,000 x 100
Return on Equity = 25%
Why is the Return on Equity ratio important?
The ROE ratio has substantial importance for investors. They can use it to evaluate a company’s net income and determine its overall profitability for its shareholders. The ROE ratio is useful for investors looking to invest in a company’s stocks. Usually, shareholders receive their earnings after deducting all other expenses from the company’s revenues.
Therefore, the ROE ratio can help determine a company’s excess remaining profits attributable to shareholders. Using this information, investors can decide if they will get favourable returns on their investments. Similarly, companies may also use the ratio internally to determine how efficiently they are utilizing their equity.
For the best results, it is always necessary for the user to look at the ratio comparatively. They can either compare it with the company’s historical performances or similar companies in the same industry. On its own, the ROE ratio does not provide meaningful information.
Conclusion
The Return on Equity ratio is a metric used by investors to evaluate a company’s profitability. It shows the efficiency of a company’s management in utilizing its equity balances to generate profits. The ROE ratio can be useful for both investors and companies in evaluating performance. However, it is best to use ratio comparatively.
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