Return on Equity ratio formula is a crucial Efficiency ratio, which tells us how much Return on equity capital or shareholder’s equity a company has made for its shareholders. In addition, it shows how well that company is performing compared to its industry.
Know what ROE and ROCE are?
In simple language, learn about Return on Equity (ROE) and Return on Capital Employed (ROCE).
In this article, we will know which financial ratio is more important to choose a good stock, Return on Equity or Return on Capital Employed. And with this, we will also know that many companies increase the return on equity even by taking loans, seeing as an everyday investor often gets cheated. Because a company with a high return on equity doesn’t need to be an excellent company, this company can also be immersed in debt. How can you protect yourself by investing in such companies? And how expert investors calculate return on equity with Dupont’s analysis of return on equity is an advanced-level technique. Let’s start with this article.
What is Return on Equity ratio?
Return on Equity or ROE is one of the essential efficiency ratios, which tells us how much return or profit a company is earning on its equity capital or shareholders’ equity. And this is one of those critical efficiency ratios which also help the investor to choose a good stock. Due to this, they get to know how much profit the company is making in their company’s stake. And it also shows how well that company is performing compared to its industry in terms of profits.
What is the formula of Return on Equity ratio, and how to calculate it?
To calculate return on equity, we get information from two places,
- The first is the profit and loss statement and
- The second is the balance sheet.
The formula for return on equity is something like this,
Return on Equity = Net Income / Average Shareholder’s Equity
Return on Equity (ROE) = Net Income / Ave. Shareholder’s Equity
or else
Return on Equity = Profit After Tax / Net-worth
Return on Equity (ROE) = PAT/Net-worth
So let’s understand this formula a little better:
To calculate return on equity, we must divide net income or profit after tax by average shareholders’ equity or net worth.
We have already learned that we get net income or profit after tax from profit and loss statements.
And we get information about average shareholder equity or net worth in the balance sheet. Shareholder’s equity is that amount that is like a loan given by the shareholders to the company. We have to use these two formulas to calculate,
- Shareholders’ Equity = Total Assets – Total Liabilities
Shareholder’s Equity = Total assets – total liability
And after this
2. Average Shareholders’ Equity = (Shareholders’ Equity at the beginning + Shareholders’ Equity at the End) / 2
Average shareholders’ equity = (Beginning shareholders’ equity + Ending shareholders’ equity) ÷ 2
And thus, the more simple formula to calculate Return on Equity becomes something like this,
Return on Equity = Net Income / {(Shareholders’ Equity at the beginning + Shareholders’ Equity at the end) / 2}
Return on equity = Net income ÷ ((Beginning shareholders’ equity + ending shareholders’ equity) ÷ 2).
And while calculating it, keeping two things in mind is essential.
The first thing is that the time of both Net Income and Everest Shareholder Equity should be identical.
And secondly, this formula fits more accurately on companies with tangible assets.
And the essential thing while calculating the Return on Equity is to compare it with the general industry. Only then will we get the correct result?
Let’s try to understand Return on Equity with the help of some examples.
Example of Return on Equity:
Here we are talking about the travel service provider Easy Trip Planners Ltd. Let’s take an example and calculate this company’s 2022 return on equity.
Step 1:
For this, we will download the annual report of this company for 2022. Therefore, you get the annual report free of cost from the company’s site or any screener website.
Step 2:
After this, we will go to the Consolidated Financial Statements section of the Annual Report of this company. We will know which page this information is available from the index.
Step 3:
For Shareholders’ Equity, we will go to the Equity section of the Balance Sheet, and from there, we will extract the data of Total Equity. So for that, we will add the Total Equity of 2 consecutive years and divide it by two, and in this way, we will get the Average Shareholders’ Equity.
Average Shareholders’ Equity = (2358.63+1626.64)/2 = 1992.64
Step 4:
After that, we will go to the profit and loss statement, and from there, we will pick up the net profit data.
Step5:
And then, in the final step, we will use that formula to calculate the return on equity and divide the net profit by the average shareholders’ equity. And we will multiply the final value by hundreds.
Return on Equity = (1059.22 / 1992.64)*100 = 53.16%
And in this way, by following only these five steps, we can calculate the Return on Equity of any stock.
Just keep in mind if the company has issued a preference dividend, we will calculate it by subtracting it from the net profit.
So come on. Once more, let us try to understand the return on equity better with the help of another example.
Here we will introduce you to this Design & Technology Service Provider, Tata Elxsi Ltd. Let’s take an example and calculate this company’s 2022 return on equity.
Step 1:
For this, we will download the annual report of this company for 2022. Therefore, you get the annual report free of cost from the company’s site or any screener website.
Step 2:
After this, we will go to the Consolidated Financial Statements section of the Annual Report of this company. We will know which page this information is available from the index.
Step 3:
For Average Shareholder’s Equity, we will go to the Equity section of the Balance Sheet, and from there, we will extract the data of Total Equity. For this, we will add the Total Equity of 2 consecutive years and divide it by two, and in this way, we will get Average Shareholder’s Equity.
Average Shareholders’ Equity = (160090.29+135217.15)/2 = 147653.72
Step 4:
After that, we will go to the profit and loss statement, and from there, we will pick up the net profit data.
Step5:
And then, in the final step, we will use that formula to calculate the return on equity and divide the net profit by the average shareholders’ equity. And we will multiply the final value by hundreds.
Return on Equity = (54967.15 / 147653.72)*100 = 37.23%
And in this way, by following only these five steps, we can calculate the Return on Equity of any stock.
AndIn this way, comparing this return on equity with the average return on equity of the related industry of this company, we will get to know how efficient the management is in using the equity capital properly and how much the company is in the sector compared to the rest of the company. Domination
What are the disadvantages of Return on Equity ratio?
If the reason for the increase in return on equity is the improvement in net income, which is due to the rise in the price of the equivalent product, or by increasing productivity, or by improving the quality of the product, or reducing the quantity of the product, then in such a situation This indicates an improvement. And this return on equity is a perfect parameter to check the quality of the company’s management and how efficiently it uses the shareholders’ equity to generate good returns compared to its general industry.
But there are two more ways by which the Return on Equity ratio can be increased, such as.
- Return on equity can be increased by issuing cash dividends by the company. or else
- Return on equity can also be increased by taking more debt by the company.
Let us know that,
How Cash Dividends Decrease Shareholder Equity:
Suppose a company, X Y Z Ltd., has decided to pay its shareholders a dividend of ₹ 1. And suppose the number of outstanding shares of this company means that the number of shares available in the market is 100000. So in this situation, the company will have to pay its shareholders a dividend of ₹100000.
So when we go to the retained earnings section of the shareholders’ equity of the company’s balance sheet, we see that the company has Rs.1,000,000. And as the company has to pay a cash dividend of ₹ 100000 to its shareholders, in this case, ₹ 100000 will be deducted from the retained earnings section of the company and added to the dividend payables sub-account of the liability section. So, the shareholder’s equity will reduce by ₹100000 to ₹900000 only. And till this dividend is not issued to the shareholders, it will keep looking in the liability section of the company, and due to this, the company’s liability will increase for some time.
When the payment of this cash dividend is given, then this amount of one lakh, the Dividend Payables Sub Account is part of the Reliability Section and the Cash Sub Account, which is part of the Assets Section, is deducted from both places.
And as we’ve already seen, the formula for shareholders’ equity is assets – liabilities, so any reduction in assets due to this reduces shareholders’ equity.
How Financial Leverage Reduces Shareholder Activity:
Let us understand this with the help of an example; suppose the company is SYZ Ltd. its footing results will go into two case studies. In the first case where the total capital of this company is available in the form of equity, i.e. Hundred per cent equity and that too in the second case, In which the company’s capital is 50% equity and 50% debt.
Here in companies where there is a hundred per cent equity capital, in that case, the return on equity of the company is less compared to the second case where the money is 50% equity and 50% debt. The return on equity is double in comparison to the first.
Here we can see that if the company increases the debt, i.e. takes more financial leverage, then in that case, the return on equity rises a lot. And for what many companies do this so that they can show good numbers to their directors in Return on Equity.
Let me give you another example where this will be very clear. Here we have a company X Y Z Limited. The other company is ABC Limited.
And here we can see clearly, that Company XYZ Limited’s Revenue, i.e. Sales and Net Profit, are more compared to Company ABC Limited. But in Company ABC Ltd., the capital is 100% in equity and 100% in debt, while in Company XYZ, the money is 100% in equity. That is why in spite of Company XYZ Ltd. performing better than Company ABC Ltd., the Return on Equity of Company Ltd. is much higher compared to Company XYZ Ltd.
It must have been clear that finance leverage can quickly increase the return on equity by reducing the shareholder’s equity.
And while investing, it is imperative to keep this in mind through which the company’s capital has come. Because the companies increase their capital by taking a lot of debt, they have to pay a considerable loss, especially in times of recession. Due to this, the investors of these companies also suffer huge losses.
For example:
- Mukta Art Limited
- Mahindra Holiday Inn Resort India Limited
and others |
So you have seen how we can get cheated by not doing the accounting of the loan and investing in the wrong company.
And return on equity Dupont analysis is used to correct this flaw.
And to meet this deficiency, we use another financial ratio called Return on Capital Employed (ROCE).
And the formula for Return on Capital Employed, i.e. ROCE, is,
Return on Capital Employed = Operating Profit (EBIT) / Capital Employed
And in the formula for Return on Capital Employed, we also include debt and equity capital.
Conclusion:
And if we talk about which financial or efficiency ratio is better between Return on Equity ratio and Return on Capital Employed?
The answer is that when there is no debt on the company or the amount of debt is very less compared to equity, then in that case we can get better results from Return on Equity.
But in the case of capital intensive industries such as telecom industry, manufacturing industry and many other industries in which the cost is very high and the amount of debt is also high, in the case of such companies, the return on capital employed gives much better results.
In this way, along with Return on Equity, both Financial Ratios and Efficiency Ratios are very important at their respective places to select a good stock.
And when these two ratios are used with debt equity ratio, then we get to see very good results and really a good company comes in front of us from investment point of view.
