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,
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.
⇨ Rs. 6500000
PBT (Profit Before Tax) = EBIT – Interest Expenses
$$Return\quad on\quad Equity=\frac { Net\quad Profit }{ Total\quad Equity } $$
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
- 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
Net Profit = PBT – Tax
⇨ 3000000 – 30% of 3000000
⇨ Rs. 2100000.00
Return on Equity = Net Profit / Total Equity
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
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
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
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%
Hence, Return on Common Equity = 41/120 or 0.3417 or 34.17%
