Return on Equity

Return on Equity - is one of the most important ratios, showing profitability of the company. It shows how profitable the money of investors are being used in the company and what wealth they are bringing to the investor. This ratio shows how much of the profit belongs for the shareholders equity. The ratio is calculated by dividing net income by equity. Equity is the difference between the assets in the company and its liabilities and they are taken from a balance sheet.

If the company has big loans, then liabilities are very large in the company, so the equity part, in comparison with liabilities, is lower. If the liabilities are needed to pay interest, it will decrease the profit of the company. Other factor is sales - if the sales are getting low, it means that for the same fixed costs and product prices, the profitability of the company will go down. As you can understand, for the calculation of this ratio a lot of factors are included.

It is useful to calculate several different ROE’s over the period when analyzing company’s profitability. In this case the investor will be able to see the changes in the company and trends of profitability over the period. The investor should compare Return on equity ratio during few years period if he wants to see, how the shareholders equity is reinvested over the period.

Return on equity ratio shows the effectiveness of equity usage. If the company earned 500000 Euros of net profit which is already decreased by the taxes, depreciation and financial expenses, and had equity of 2 million Euros, then Return on equity for this period would be 0,25 or 25%, which means that every invested Euro brings 25 Euro cents of return. This is very good ratio for this situation, because the ratio is very high. Usually the ratio is between 10-20 percent. There might be a scenario that the equity during the period is changing, so the investor should calculate an average of it.

The company’s situation would be declining if the level of assets would be rising, which could be inventory of the company and the debts of customers. So if the company is working profitable, and the assets are declining, the ROE ratio would be getting higher. The purpose for the investor is to choose the most successful company that would be generating profits from its activities by reducing inventory and debt of customers, but not from increasing its liabilities by taking loans and increasing debt for the suppliers. To evaluate the borrowed capital the investor should also calculate Return on capital employed ratio.

To conclude with Return on equity ratio, it would be good to remember that calculation of the only one ratio is not good way to evaluate the whole company, because increase in one ratio can show decrease in another, so clever investor should check not only the ratios, but also look through the balance sheet and profit and loss statement, which would show which factors influenced the ratios that the company has at the moment. It would help the investor to see the overall picture of the ratio’s place in the company and decide whether the company is worth of investing or not.

Other ratio groups:
EBITDA
Value ratios
Efficiency ratios
Profitability ratios
Liquidity ratios
Leverage ratios
Other financial ratios
EBITDA
Efficiency ratios