The formula you need: return on equity to help investors. Profitability as an indicator of company performance What does return on equity mean?

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What is Return on Equity

Return on equity (ROE), also used the term "return on equity") - a financial ratio that shows the return on investment of shareholders in terms of accounting profit. This accounting measurement method is similar to return on investment (ROI).
This relative performance indicator is expressed in the formula:
The net profit received for the period is divided by the organization's equity capital.
The amount of net profit is taken for the financial year, excluding dividends paid on ordinary shares, but taking into account dividends paid on preferred shares (if any). Share capital is taken without taking into account preference shares.

The benefits of ROE ratio

The financial return indicator ROE is important for investors or business owners, since it can be used to understand how effectively the capital invested in the business was used, how effectively the company uses its assets to generate profit. This indicator characterizes the efficiency of using not the entire capital (or assets) of the organization, but only that part of it that belongs to the owners of the enterprise.
However, Return on Equity is an unreliable measure for determining the value of a company, as it is believed that this indicator overestimates economic value. There are at least five factors:
1. Duration of the project. The longer it takes, the more inflated the indicators are.
2. Capitalization policy. The smaller the share of capitalized total investments, the greater the overstatement.
3. Depreciation rate. Uneven depreciation results in higher ROE.
4. The lag between investment costs and the return from them through cash inflows. The greater the time gap, the higher the degree of overestimation.
5. Growth rate of new investments. Fast-growing companies have lower Return on Equity.

Let's sort it out return on equity. In foreign sources, the return on equity ratio is designated as ROE – Return On Equity (or Return on shareholders’ Equity), and shows the share of net profit in the equity capital of the enterprise.

Let's start by defining the economic essence of the return on equity ratio, then we will provide a calculation formula for both domestic and foreign forms of accounting reporting and do not forget to talk about the standards for this indicator.

Return on equity. Economic essence of the indicator

Who needs this return on equity ratio?

This is one of the most important ratios used by investors and business owners, which shows how effectively the money invested in the enterprise was used.

The difference between return on equity (ROE) and return on assets (ROA) is that ROE does not show the performance of all assets (like ROA), but only those that belong to the owners of the enterprise.

How to use return on equity ratio?

As mentioned above, this indicator is used by investors and owners of an enterprise to evaluate their own investments in it. The higher the ratio, the more profitable the investment. If the return on equity is less than zero, then there is reason to think about the feasibility and effectiveness of investment in the enterprise in the future. As a rule, the value of the coefficient is compared with alternative investments in shares of other enterprises, bonds and, in extreme cases, in a bank.

It is important to note that too high a value of the indicator can negatively affect the financial stability of the enterprise. Don't forget the main law of investment and business: more profitability - more risk.

Return on equity. Calculation formula for balance sheet and IFRS

The formula for the return on equity ratio consists of dividing the enterprise's net profit by its equity:

Return on Equity Ratio = Net Profit/Equity

For convenience, all profitability ratios are calculated as a percentage, so do not forget to multiply the resulting value by 100.

According to the domestic form of financial statements, this ratio will be calculated as follows:

Return on equity ratio = line 2400/line 1300

The data for the formula is taken from the “Profit and Loss Statement” and “Balance Sheet”. Previously, in the old form of financial statements (before 2011), the coefficient was calculated as follows:

Return on equity ratio = line 190/line 490

According to the IFRS system, the coefficient has the following form:

DuPont formula for calculating return on equity

To calculate the return on equity ratio, it is often used Dupont formula. It breaks the coefficient into three parts, the analysis of which allows you to better understand what influences the final coefficient to a greater extent. In other words, this is a three-factor analysis of the ROE ratio. Dupont's formula is as follows:

Return on equity ratio (Dupont formula) = (Net profit/Revenue) * (Revenue/Assets)* (Assets/Equity)

The Dupont formula was first used in financial analysis in the 20s of the last century. It was developed by the American chemical corporation DuPont. Return on equity (ROE) according to the DuPont formula is divided into 3 components: operating efficiency (return on sales),
efficiency of asset use (asset turnover),
leverage (financial leverage).

ROE (according to the DuPont formula) = Return on sales * Asset turnover * Leverage

In fact, if you reduce everything, you get the formula described above, but such a three-factor separation of components allows you to better determine the relationships between them.

Return on equity ratio. Calculation example for KAMAZ OJSC

To assess return on equity, it is necessary to obtain the financial statements of the company under study. On the official website of the KAMAZ OJSC enterprise you can get financial data for the last 4 years. An alternative option is to use the InvestFunds service, which allows you to obtain data for several quarters and years. The figure below shows an example of importing balance data.

Calculation of the return on equity ratio for KAMAZ OJSC. Income Statement

Calculation of the return on equity ratio for KAMAZ OJSC. Balance sheet

Let's calculate the coefficients for 4 years:

Return on equity ratio 2010 = -763/70069 = -0.01 (-1%)
Return on equity ratio 2011 = 1788/78477 = 0.02 (2%)
Return on equity ratio 2012 = 5761/77091 = 0.07 (7%)
Return on equity ratio 2013 = 4456/80716 = 0.05 (5%)

There is an increase in the indicator from -1% to 5% over 4 years. However, investing in shares of this company is not advisable, because the profitability ratio is less than investing in alternative projects. For example, in 2013, the bank deposit rate was about 10%. It was more effective to invest free funds in a deposit than in KAMAZ OJSC (5%<10%).

Return on equity. Standard

The average ROE in the US and UK is 10-12%. For inflationary economies, the coefficient is higher. According to the international rating agency S&P, the return on equity ratio of Russian enterprises was 12% in 2010, the forecast for 2011 was 15%, for 2012 – 17%. Domestic economists believe that 20% is a normal value for return on equity.

The main criterion for assessing the return on equity ratio is to compare it with the alternative return that an investor can receive from investing in other projects. As discussed in the example above, investing in KAMAZ OJSC was not effective.

Profit is the main thing. Of course, there are people who disagree with this. Some argue that liquidity and cash flow are more important (and too often ignored). But no one will deny that it is necessary to control the profitability of a company to ensure its financial health.

There are several ratios that you can look at to assess whether your company can generate revenue and control its expenses.

Let's start with return on assets.

What is return on assets (ROA)?

In the broadest sense, ROA is the ultra version of ROI.. Return on assets tells you what percentage of each dollar invested in the business was returned to you as profit.

You take everything you use in your business to make a profit - any assets such as cash, fixtures, machinery, equipment, vehicles, inventory, etc. - and compare it all to what you were doing during that period in terms of profit.

ROA simply shows how effectively your company uses its assets to generate profits.

Take the infamous Enron. This energy company had a very high ROA. This was due to the fact that she created separate companies and “sold” her assets to them. Since its assets were thus taken off the balance sheet, the company appeared to have a higher return on assets and equity. This technique is called "denominator control".

But "denominator management" is not always a scam. In fact, it's a smart way to think about how to run a business.

How can we reduce assets so that we can increase our ROA?

You're essentially figuring out how to do the same job at a lower cost. You may be able to restore it instead of throwing away money on new equipment. It may be a little slower or less efficient, but you will have lower assets.

Now let's look at return on equity.

What is return on equity (ROE, from the English. Return on Equity)?

Return on equity is a similar ratio, but it looks at equity, the net worth of a company as measured by accounting rules. This metric tells you what percentage of profit you are making for each dollar of capital invested in your company.

This is an important ratio no matter what industry you're in, and is more relevant than ROA for some companies.

Banks, for example, receive as many deposits as possible and then lend them out at a higher interest rate. Typically, their return on assets is so minimal that it is truly unrelated to how they make money.

But every company has its own capital.

How to calculate return on equity?

Like ROA, this is a simple calculation.

net profit/equity = return on equity

Here's an example similar to the one above, where your profit for the year is $248 and your equity is $2,457.

$ 248 / $ 2,457 = 10,1%

Again, you may be wondering, is this a good thing? Unlike ROA, you want ROE to be as high as possible, but there are limits.

This can be explained by the fact that one company may have a higher ROE than another company because it borrowed more money and therefore had more debt and proportionately less investment put into the company. Whether this is positive or negative depends on whether the first company uses its borrowed money wisely.

How do companies use ROA and ROE?

Most companies look at ROA and ROE in conjunction with various other profitability measures such as gross profit or net profit. Together, these numbers give you an overall idea of the company's health, especially compared to its competitors.

The numbers themselves aren't that useful, but you can compare them to other industry results or to your own results over time. This trend analysis will tell you which direction your company's financial health is heading.

Often investors care about these ratios more than managers within companies. They look at them to determine whether they should invest in the company. This is a good indicator of whether the company can generate profits that are worth investing in. Likewise, banks will look at these figures to decide whether to lend to the business.

Managers in some industries find ROA more useful in decision making. Since this indicator reflects the profit generated by the main activity, it can be used by industrial or manufacturing companies to measure efficiency.

For example, a construction company might compare its ROA to its competitors and see that its rival has a better ROA, even though its profits are high. This is often the decisive push for these companies.

Once you have figured out how to make more profit, you figure out how to do it with fewer assets.

ROE, on the other hand, is more relevant to the board of directors than to the manager, which has little influence on how much stock and debt the company has.

What mistakes do people make when using ROA and ROE?

The first caveat is to remember that none of these numbers are completely objective. Sales are subject to revenue recognition rules. Costs are often a matter of estimation, if not guesswork. Assumptions are built into both the numerator and denominator of the formulas.

Thus, the earnings reported on the income statement are a matter of financial art, and any ratio based on these figures will reflect all of these estimates and assumptions. The ratio is still useful, just remember that estimates and assumptions will always change.

Another problem is that you are using a number obtained over a certain period of time (last year's profit) and comparing it with a number at a certain point in time (assets or capital). It's usually wise to take an average of assets or stocks so that "you're not comparing apples and oranges."

With ROE, you also have to remember that equity is book value. The true cost of capital is the market capitalization of the company's shares. When you interpret this figure, keep in mind that you are looking at book value, and market value may be different.

The risk is that since book value is typically lower than market value, you may think you're getting a 10% ROE when investors think your return is much less.

You probably won't make an investment decision based on just one of these numbers, or even both of them. They are part of a larger group of indicators that help you understand the overall health of your business and how you can influence it.

When analyzing the performance of companies, profitability indicators are often used. Typically, the following 4 main types of profitability ratios are calculated: return on sales, return on total capital, return on equity, return on EBITDA. Return on sales shows what share net profit occupies in total sales. Accordingly, the formula for calculating profitability of sales is as follows:

Return on sales = net profit / sales volume (revenue)

It is clear that the higher this indicator, the better. However, there will be significant differences in its values when analyzing companies in different industries. Comparisons of return on sales should be made for peer companies. The reasons, for example, for an increase in this indicator can be the following: either the numerator of our ratio increases (i.e. profit), or the denominator decreases (sales volume falls), or the first and second simultaneously. Profits can change for a variety of reasons, not necessarily due to an increase in the price of goods or services.

As for the decrease in sales volume, it is important to understand the reasons why this is happening. Webinars from Forex broker Gerchik & Co will help you with this. If sales decrease against the background of an increase in price, then this development of events can be regarded as normal. If sales are falling due to falling interest in the company's products, then this situation should alert investors. In this case, there may even be an increase in profitability of sales due to a short-term increase in profit (profit is a very variable thing and depends on many factors, such as cost reduction, a sharp decrease in depreciation charges and other accounting tricks). Summarizing the above, we can say that analyzing the profitability of sales is a very vague task, but with all the shortcomings of this method of analysis, it allows you to get an initial picture of the company’s profitability and compare similar companies.

Return on total capital gives us an idea of how effectively the company manages all its capital - its own and borrowed capital. The return on total capital is calculated using the formula:

Return on total capital = net profit / total capital.

The value of this indicator is strongly influenced by the amount of borrowed funds and the cost of debt servicing. The higher the share of borrowed funds under which the company raises funds and the higher the percentage, the lower the net profit and, accordingly, the lower the return on total capital. This indicator is very important when analyzing business performance. Based on the return on total capital, you can compare not only companies in different industries, but also determine the most profitable industries where you should invest your money. Return on equity (shareholder's) capital demonstrates a company's success in increasing share capital or its failure to generate sufficient levels of profitability. The return on equity formula looks like this:

Return on Equity = Net Profit / Shareholders' Equity.

Share capital on the balance sheet is the liability item "capital and reserves". Return on equity capital depends not so much on the profitability of the business as on the ratio of debt and equity capital. This relationship is called the leverage effect. The essence of the leverage effect is as follows: a company, using borrowed funds, increases or decreases the return on equity capital.

The decrease or increase in return on equity capital depends on the average cost of borrowed capital (average interest rate) and the amount of financial leverage. Financial leverage is the ratio of debt and equity capital of an organization. Formula for calculating financial leverage:

Financial leverage = debt capital / equity capital.

If you compare a company's return on equity over the past few years with other investment instruments, such as government bond yields or bank deposit rates over the same period, you can learn a lot about the company's level of profitability. A company that for a number of years has received a return on equity lower than that of a bank deposit, even if it exists for a long time, will bring almost nothing to its shareholders. It is better if the return on equity capital is several times higher than the rates on bonds.

EBITDA margin EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization, EBITDA) is an indicator of a company’s profit before interest, taxes, depreciation and amortization. EBITDA margin or EBITDA margin is calculated using the formula:

EBITDA margin = EBITDA / Sales revenue

EBITDA margin shows the company's profitability in terms of primary profit, i.e. by EBITDA. Currently, this indicator is very popular among analysts. The explanation for this is simple - EBITDA shows the company's profit before various payments. These payments are either deferred in time, for example, taxes, so this money can be re-rolled by the company and there is no need to pay interest on it, or in the case of depreciation, the money does not leave the company at all, which allows it to be used in the future. As for interest payable, it is necessary to clarify the structure of the debt.

Typically, bond loans require payments of one or two payments per year (sometimes more often), while bank loans require more frequent payments, so it is preferable to pay interest on bonds, since they are less frequent, which allows the company to use the money for current needs for some time. Finally, it is worth noting that all profitability indicators are quite variable, so it is better to carry out the analysis not of a separate period of time, but over several years in order to identify a trend.

Profitability indicators

Product profitability- the ratio of (net) profit to total cost
Return on fixed assets- ratio of (net) profit to the value of fixed assets
Return on sales(Margin on sales, Return on sales) - the ratio of (net) profit to revenue.
Basic return on assets ratio(Basic earning power) - the ratio of profit before taxes and interest received to the total amount of assets
Return on assets (ROA)- the ratio of operating profit to the average amount of total assets for the period
Return on equity (ROE):
- the ratio of net profit to the average amount of equity capital for the period;
- The ratio of earnings per common share to the firm's book value per share.
Return on invested capital (ROIC)- the ratio of net operating profit to the average equity and borrowed capital for the period
Return on Capital Employed (ROCE)
Return on total assets (ROTA)
Return on business assets (ROBA)
Return on net assets (RONA)
Profitability of markup(Profitability of the margin) - the ratio of the cost of a product to its selling price
etc. (see profitability ratios in financial ratios)

Return on sales

Profitability of sales(English) Profit margin) - coefficient profitability, which shows the share of profit in each ruble earned. It is usually calculated as the ratio of net profit (or profit before taxes) for a certain period to the sales volume expressed in cash for the same period.

Return on Sales = Net Profit / Revenue

Return on sales is an indicator of a company's pricing policy and its ability to control costs. Differences in competitive strategies and product lines cause significant variation in return on sales values across companies. Often used to evaluate the operating efficiency of companies. However, it should be taken into account that with equal values of revenue, operating costs and profit before tax for two different companies, the profitability of sales can vary greatly due to the influence of the volume of interest payments on the amount of net profit.

Return on assets

Return on assets(English) return on assets, ROA net profit received for the period, by the total assets of the organization for the period. One of the financial ratios is included in the group of profitability ratios. Shows the ability of a company's assets to generate profit.

Return on equity

Return on equity(English) return on equity, ROE) - a relative indicator of operational efficiency, the quotient of dividing the net profit received for the period by the organization's own capital. One of the financial ratios is included in the group of profitability ratios. Shows the return on shareholder investment in terms of accounting profit.

Return on equity = Net profit/Average shareholders' equity for the period

Notes

Sources

Brigham Y., Erhardt M. Analysis of financial statements // Financial management = Financial management. Theory and Practice. - 10th ed./Trans. from English under. ed. Ph.D. E. A. Dorofeeva.. - St. Petersburg: Peter, 2007. - P. 131. - 960 p. - ISBN 5-94723-537-4

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See what “Return on Equity” is in other dictionaries:

A company's net income expressed as a percentage of equity. In English: Return on equity English synonyms: ROE See also: Profitability ratios Equity capital Financial Dictionary Finam ... Financial Dictionary

The ratio of a company's net income to equity, expressed as a percentage. Dictionary of business terms. Akademik.ru. 2001 ... Dictionary of business terms

Net return on equity (ROE)- net return on equity (ROE) is the ratio of net profit to the average value of equity capital for the period... Source: Guidelines for assessing the effectiveness of investment projects (approved... ... Official terminology

COMPANY'S RETURN ON EQUITY- the company’s net profit as a percentage of equity capital... Large economic dictionary

The ratio of the enterprise's net profit to the average equity capital. In English: Net profitability of equity See also: Profitability ratios Own capital Financial dictionary Finam ... Financial Dictionary

net return on equity- The ratio of the enterprise’s net profit to the average equity capital. Topics: economics EN net profitability of equity… Technical Translator's Guide

THE RATIO of earnings before interest and taxes multiplied by 1 minus the tax rate to the sum of debt and equity capital. Return on invested capital characterizes the profitability of a company when investing through... ... Financial Dictionary

A coefficient characterizing profitability per unit of invested capital. It is calculated as the ratio of net profit to the average amount of equity capital. Dictionary of business terms. Akademik.ru. 2001 ... Dictionary of business terms

Profitability (German rentabel profitable, profitable), a relative indicator of economic efficiency. Profitability comprehensively reflects the degree of efficiency in the use of material, labor and monetary resources, as well as natural... ... Wikipedia

- (German rentabel profitable, useful, profitable), a relative indicator of economic efficiency. Profitability comprehensively reflects the degree of efficiency in the use of material, labor and monetary resources, as well as... ... Wikipedia

Books

, Savitskaya Glafira Vikentievna, The book examines the essence of the efficiency of entrepreneurial activity, developed a structured system of indicators to identify its level and a methodology for their calculation. Made… Category: Accounting and auditing Series: Scientific Thought Publisher: INFRA-M,
Analysis of the efficiency and risks of business activities. Methodological aspects. Monograph, Savitskaya G.V. The book examines the essence of business efficiency, develops a structured system of indicators to identify its level and a methodology for their calculation. Made... Category:

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