Return on Equity (ROE), Its Significance and Limitations

Return on equity (ROE) is a financial parameter which is a measure of net profit generated by the company against each dollar of equity amount contributed by its shareholders. It tells us about, how profitable the company is, taking into account the contribution of its shareholders.

How the Return on Equity (ROE) is Calculated?

Return on Equity (ROE) is calculated by using the following formula:

Return on Equity (ROE)= Net Annual Income/Shareholder’s Equity

Net Income= Post tax profits of the company

Net income can be found at the bottom of income statement and hence it is called the ‘bottom line’.

Shareholder’s equity= Funding sources of the company excluding liabilities (debt)

It is fund in the balance sheet of the company. You can also calculate the shareholder’s equity by subtracting companies’ liabilities from its assets.

Example 1:

In the year 2022, a company XYZ Ltd. has booked a net income of $33 Million, from which $ 3.5 Million were paid to preference shareholders as dividends. Furthermore, the company infused an equity of $12 Million in the middle of year and as a result, the total equity of the company reached to $65 Million. Calculate the ROE of the company form the given data.

Solution:

Equity at the Start of the Year = Equity at the End of the Year – Equity Infused – (Net Income – Preferred Dividend)

• Equity at the Start of the Year = $65.00 million – $12.00 million – ($33.00 million – $3.5 million)
• Equity at the Start of the Year = $23.50 million

One calculates the Average Shareholder’s Equity using the formula given below:

Average Shareholder’s Equity = (Equity at the Start of the Year + Equity at the End of the Year) / 2

= ($23.50+$65.00)/2= $44.25

One calculates (ROE) using the formula given below:

ROE = (Net Income – Preferred Dividend) / Average Shareholder’s Equity

Hence ROE= ($33-$3.5)/$44.25= 66.67%

Therefore, the company generated a profit at an ROE of 40.0% during the year 2022.

Significance of Return on Equity (ROE)

The Return on Equity (ROE) provides us an insight about how efficiently the existing and new equity invested by the shareholders is being utilized by the company.

High Return on Equity (ROE): The higher the ROE ratio, the more the company gains in net profits with the equity provided by its investors/ shareholders.

Low Return on Equity (ROE): The lower the ROE ratio, the less the company is earning in net profits with the equity contributed by its investors/ shareholders.

Generally, if the return on equity (ROE) is steadily increasing, it means that the performance of the company is getting better and it is creating more value for its investors.

ROE must be compared to the historical ROE of the company and to the industry’s ROE average, then only you will get complete picture of the company’s performance.

Limitations of Return on Equity (ROE)

There are following limitations of Return on Equity (ROE):

(i) This matrix cannot be used as standalone, as it is affected by discretionary management decisions and one-time events.

a. Stock Buyback: Stock buyback may decrease the shareholder’s equity and hence could artificially increase the ROE.

b. Dividend Issuance: The dividends come straight out of the retained earnings and hence it increases the ROE.

(ii) It can be misleading in the case of new companies where the initial capital requirement is high, resulting in a lower ROE.

(iii) The ROE can be manipulated using various accounting techniques, such as increasing the project life or decreasing the depreciation rate.

Conclusion

ROE compares how much income a company is generating as compared to its shareholder’s equity. ROE is one of the financial parameters, which are used to access the performance of a company. It helps investors in taking the investment decisions in a company.

Also read: Return on Capital Employed (ROCE), Its Utility and Limitations