# Return on Equity (ROE)

Return on Equity is a type of Profitability Ratio that determines the Return on Total Shareholder’s Fund in a Company. It is a measure of how good a company is using the Assets to create profit. Return on Equity is also known as Return on Net Worth.
$$Return\quad on\quad Equity=\frac { Net\quad Profit }{ Total\quad Equity }$$
Net Profit = Profit after Excluding all Expenses and Tax = Net Sales – (Cost of Goods Sold + Operating Expenses + Depreciation /Amortization + Interest Expenses + Tax paid)Where,
• And Total Equity = Total Shareholder’s Fund = Equity Share Capital + Reserves and Surplus + Preferred Equity
• Return on Equity (ROE) multiplied by 100 provides the ROE in percentage terms.

## Return on Common Equity

• Return on Common Equity = (Net Profit – Preferred Dividends) / Common Equity
Where,
• Preferred Dividend = Dividend Paid on Preferred Equity
• And Common Equity = Equity Share Capital + Reserves and Surplus

If the Company is having no Preferred Equity, then the Return on Common Equity is the same as Return on Equity.
Preferred Equity shares that are issued on a preference basis and have a Fixed Rate of Dividend.

## Significance and Interpretation

• Return on Equity is an important fact from a shareholder’s point of view, a high ROE attracts an investor and a low ROE is not considered good for investing.
• Considering only the Net profit figure may be an incomplete analysis as Net Profit Ratio does not consider the total funds available, hence ROE is a better measure to judge the profitability of a company.
• High ROE can be obtained either due to increased Net profit (Big Numerator) or reduced Total Equity (Small Denominator), the former i.e. Increased Net profit is good and favourable for investors but the former i.e. Reduced Total Equity is considered to be a risk for the company.
• It must be noted that comparing the performance of two companies based on ROE is useful only if both companies belong to the same sector of the industry.

### Examples

#### Example 1:

Given below are few details of M/S XYZ Ltd., use them an calculate the Return on Equity and Return on Common equity for M/S XYZ Ltd. The rate of tax on profit is 30%.
Particulars Amount (in Rs.)
Equity Share Capital 5000000.00
Reserves and Surplus 1000000.00
Preferred Equity @10% return 500000.00
EBIT (Earnings Before Interest and Taxes) 4000000.00
Interest Expenses 1000000.00

#### Solution:

Total Equity = Equity Share Capital + Reserves and Surplus + Preferred Equity
Rs. 6500000
PBT (Profit Before Tax) = EBIT – Interest Expenses
Rs. 3000000.00
Net Profit = PBT – Tax
3000000 – 30% of 3000000
Rs. 2100000.00
Return on Equity = Net Profit / Total Equity
2100000 / 6500000
21/65
Hence, Return on Equity (ROE) = 21/65 or 0.3230 or 32.30%
Preferred Dividend = 10% of Preferred Equity
10% of 500000
Rs. 50000.00
Common Equity = Equity and Share Capital + Reserves and Surplus
Rs. 6000000.00
Return on Common Equity = (Net Profit – Preferred Dividend) / Common Equity
(2100000 – 50000) / 6000000
2050000 / 6000000
41/120
Hence, Return on Common Equity = 41/120 or 0.3417 or 34.17%