How to Calculate Return on Equity

Introduction

Return on Equity (ROE) is a financial ratio used to evaluate the profitability of a company relative to its shareholders' equity. It is one of the most commonly used measures of financial health, helping investors compare companies and sectors to see which one may offer higher returns.

In this post, we will discuss the basics of Return on Equity and how businesses can calculate their own ROE. We will also discuss why Return on Equity is an important metric for investors and how it can be used as part of a comprehensive financial analysis.

Formula for Calculating Return on Equity

Return on Equity (ROE) is a financial ratio which measures the profitability of a business over a period of time by calculating the return earned in proportion to the shareholders’ equity. It is calculated by dividing the net income by the average shareholder equity.

It is important to use accurate figures when calculating ROE as errors can result in unreliable results. The formula for calculating ROE is:

• ROE = Net Income ÷ Average Shareholder Equity

The following outlines the components used in the formula:

Net Income

Net income is the amount of money that was earned above the costs of producing a good or service, also known as the bottom line or profit. It is represented by the numbers from the income statement.

Shareholder Equity

Shareholder’s equity is the money that comes from the contributions of the owners of the company, plus any retained earnings. It is calculated by subtracting the company’s liabilities from its assets, and is represented by the numbers from the balance sheet.

Non-Cash Items

Non-cash items that impact Return on Equity (ROE) include goodwill amortization and other types of amortization. Once these items are identified and factored in, investors and business owners can gain a clear understanding of how their company's return on equity is performing.

Goodwill Amortization

Goodwill is an intangible asset that appears on a company's balance sheet. It is calculated when one company acquires another, and is based on the difference between the purchase price and the net value of the assets. Goodwill amortization is the process of spreading out the expense related to the acquisition over a set period of time. When goodwill amortization is taken into account for ROE calculations, it affects the ROE number by reducing the net income that is used to calculate the ratio. This reduces the overall return on equity number, but is an accurate reflection of the company's true performance.

Other Amortization

In addition to goodwill amortization, other types of non-cash amortization can also have an impact on ROE calculations. For example, certain types of intangible assets such as patents or trademarks are spread out over multiple years and can reduce a company's net income when factored into the equation. Like goodwill amortization, these non-cash amortizations should be included when calculating the company's return on equity. By taking into account these non-cash items, investors and business owners can get a more accurate assessment of the company's actual performance.

4. Operating Leverage

Operating Leverage (OL) is a measure of a company’s ability to use its fixed costs to increase its return on equity (ROE). It is expressed as a ratio between the percentage of total fixed costs to the total assets or total sales. The larger the ratio, the greater the Operating Leverage.

A. Impact on Return on Equity

Since fixed costs are constant, a slight increase in sales will lead to a significant increase in profit margins. This can be beneficial to companies, as operating leverage increases their profits as well as their ROE. In essence, a company has higher returns on its equity when Leverage is used.

B. Factors Affecting Operating Leverage

There are several factors that can affect an organization’s operating leverage. These include the following:

• The level of debt the company is carrying
• The volatility of the business environment
• Level of fixed costs relative to profits
• The cost of capital for the company

It is important to understand how Operating Leverage impacts a company’s ROE, and how to analyze and adjust the factors affecting it in order to maximize returns.

5. DuPont Identity

The DuPont Identity, named after the famous chemical company, is an equation used to measure the return on equity (ROE) of a business. It is calculated by taking the Net Income multiplied by Total Assets divided by Total Equity.

A. Definition

The DuPont Identity takes the form of a simple equation:

• ROE = (Net Income * Total Assets) / Total Equity

The DuPont Identity equation can also be broken down into three parts: (1) return on assets (ROA), (2) asset turnover, and (3) financial leverage. By looking at each of these components, investors can get a better understanding of a company’s ROE.

B. How It Can Be Used to Analyse the Performance of a Company

The DuPont Identity can be used to analyse the performance of a company by providing insight into the relationship between a firm’s equity, assets, and profits. By understanding the relationship between each of these three components, investors can make better decisions regarding their investment opportunities.

For example, if a company is consistently generating returns on equity that is lower than its peer group, the DuPont Identity can provide insight into where the differences are coming from. By breaking down the components of the identity and analyzing the firm on an individual basis, investors can identify any weak links and take appropriate action.

Limitations

Return on equity is an important financial indicator that tells how much profit a company generates within a given period of time. While it helps show the profitability of a company, it also has its own limitations.

High Debt Levels

A major limitation of the return on equity ratio is that during times of high debt levels, the debt holders of a company will also influence the equation as they take preference over a company's equity holders. As a result, return on equity figures may appear more favorable than they actually are.

Effect of Changes in Interest Rates

Changes in the market interest rates can also have an effect on return on equity figures for a company. When interest rates are low, a company may take on more of the higher yielding debt to help maximize profitability even though net income may remain the same. On the other hand, higher interest rates can lead to reductions in return on equity.

Conclusion

Return on equity (ROE) is an important financial ratio used to measure the profitability and efficiency of a company’s management in utilizing its resources. Calculating ROE is the best way to assess a company’s performance over time and is essential for investors when considering a potential investment. There are a few steps to follow that can help you accurately calculate your return on equity.

Summarise the Steps for Calculating Return on Equity

To accurately measure the return on equity of a business, first calculate the net income of the last financial year and divide it by the average stockholders’ equity, and multiply by 100 to arrive at the percentage. The formula looks like this: ROE = (Net Income/Average Stockholders’ Equity) x 100.

To calculate the Average Stockholders’ Equity, the most accurate approach is to take the difference between the equity figures of the start and end of the financial year, then divide it by two.

Summarise the Limitations of the Calculations

Calculating return on equity represents a business outlook, which is subject to change as the external environment changes as well. Factors such as a changing economic landscape, regulatory changes and market volatility can all contribute to the limitations of an ROE calculation. In addition, ROE is only an average value, which can mask issues of equity capital structure, debt management, or changes in accounting principles.

Although the calculation process of return on equity is relatively straightforward, the limitations of the calculation makes it a relatively not full-proof method for investors to make investment decisions.