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 on Equity = Net Profit / Total Equity
Where,
  • Net Profit = Profit after Excluding all Expenses and Tax = Net Sales – (Cost of Goods Sold + Operating Expenses + Depreciation /Amortization + Interest Expenses + Tax paid)
  • 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 favorable 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%
Join 40,000+ readers and get free notes in your email