Return On Equity Ratio | ROE Ratio | Example | Ratio Calculation | Formula

The ability of the company or the firm that generate the profit from the investment of shareholder is called Return on Equity (ROE) ratio. In simple words, we can say how much profit generated from the single stockholder equity.

If ROE is 1 then it means that the Equity of common stockholder generates 1 dollar from net income. From this investor can see that the firm use money for the generation of net income in a better way or not. So for the potential investor, it is necessary to know ROE in this way.

Return on equity is the way from which investor indicate the management that hoe effectively management use the Equity financing for the funds’ operation and for the growing of the company.

Formula

The return on equity ratio formula is equal to the Net income divided by the Shareholder’s equity. that is

Mostly for the common shareholder ROE is used. In the calculation of this ratio preffered dividend not include because of this profit not for the common stockholder.

So the calculation of the preferred dividend taken out from the net income.

There is also the equity of the average common stockholders’ use for which the beginning and ending Equity calculation is necessary.

Analysis

Return on the equity measures that the firm progress that the firm generated how much profit for the investor who invests in the firm.

It means that ROE is the profitability for the investor not for the firm. So ROE is used for the calculation of the money for the investor which investor make from the firm.

It does not tell the profit of the firm or about the firm’s assets.

When investors want to invest in the company that first of all investor want the high return on the equity ratio. Because of which it indicates that the company use the funds of investor effectively and make money. The high ratio is better than the low return on equity ratio.

For every company, there are different levels for investor and income. Through ROE investors cannot compare the company outside of their industries effectively.

When users invest in the company that first of all investor calculate the return on equity at the beginning and at the end to see the return. From this investor see the trend of the company.

Example

There is John’s tools company. It sells tools to construction company within the country. his net income is \$200,000 and its issued preferred dividends of 20,000 during the year. John also had 20,000, \$5 per common share during the year. Then the return of common equity of John is that

Return on Equity Ratio

1.80= (200,000-20,000)/(20,000×5)

From the above result, it is clear that when the preferred dividends remove from the total income John’s ROE remains 1.80. It shows that every dollar of the Equity of the common shareholder earns 1.80 \$ in his year. So we can say that the shareholder gets the 180% return of their investment. which shows the company of John is the growing company.

If the investor wants to check the growth of any company then for this investor get the average ROE ratio of 5 to 10 years of the company.

Equity Ratio

Equity ratio is investment leverage or solvency ratio which is used to measure the number of assets which are financed by the owners’ investment. This ratio can be calculated by the total equity to total assets.

This ratio is used to highlight the 2 main financial concepts of sustainable business. From the first component, we know how much assets of the company is owned by investors. Whereas the second component shows how leveraged the company is with its debt.

Equity ratio calculates the number of the company’s assets financed by the investors. And the inverse of the calculation of this ratio shows the number of assets financed by debt. If the equity ratio of the company is high it means that investors have believed in this company and want to invest in this company.

Formula

Equity ratio formula is calculated by dividing the total equity by the total assets of the company.  All the asset and equity of the company reported on the balance sheet of the company.

Equity Ratio = Total Equity/ Total assets

Analysis

If the equity ratio of the company is high then it is favourable for the company. A high ratio shows that the company is less risky and more sustainable.

As compare to debt financing equity financing is cheaper because interest is related to debt financing. So the company which has a high ratio will have low financing and financial debt cost as compared to the company which has a low equity ratio.

Example

There is the new company start by Watson with some investors. Watson wants for additional financing for the growth of the company for which he discusses with its partner. Total assets of his business are \$150,000 and total liabilities are \$50,000. Total equity of the company considers 100,000 dollars. then we can calculate the equity ratio as

Equity ratio = total equity/ total assets

Equity ratio = 100,000/150,000

=  0.67

From the equity ratio, it is clear that 67 % assets of the company owned by the shareholders, not by the creditor.

For more Financial Ratio Check:

Enterprise value

Equity multiplier