You can use several ratios to analyze the profitability of your business.
The most commonly used indicators are the return on shareholders’ equity ratio, gross profit margin, return on common shareholders’ equity, net profit margin and the return on total assets ratio.
Another is the return on equity (ROE) ratio, which indicates how much profit the company generates for each dollar of equity.
What is return on equity (ROE)?
“The return on equity ratio is a profitability ratio,” explains Dimitri Joël Nana, Director, Portfolio Risk at BDC. In other words, it assesses how effectively you and your management team use equity to generate profits.
More specifically, the return on equity ratio measures the company’s profits compared to its shareholders’ investment.
Return on equity formula
The return on equity ratio is calculated by dividing earnings after tax (EAT) by shareholders’ equity. The mathematical formula is as follows:
Example of return on equity calculation
Let’s say that ABC Co. has $400,000 in shareholders’ equity and $600,000 in debt, totalling $1,000,000 in assets, and that earnings after tax total $50,000.
The shareholders’ equity consists of four sub-components, namely common shares, preferred shares, contributed capital and retained earnings, as follows:
- Common shares: $200,000
- Preferred shares: $100,000
- Contributed capital: $50,000
- Retained earnings: $50,000
We then obtain the return on equity ratio by dividing EAT ($50,000) by shareholder equity (i.e. $400,000, or $200,000 + $100,000 + $50,000 + $50,000) as follows:
Interpreting your return on equity
Calculating your own company’s return on equity ratio can help you better understand and ultimately improve your company’s financial performance, explains Nana. All things being equal, investors prefer to invest in companies that have a high ratio.
As with many other ratios, the return on equity ratio is usually used to perform two types of analyses:
1. Time analysis: To examine your own ratio’s development over time
2. Competitive analysis: To compare your ratio to that of similar companies
“On its own, out of context, the calculation’s result means little. For it to be really useful, you either have to make historical comparisons with your previous ratio or compare your ratio with that of similar companies in your industry,” says Nana.
What is a good return on equity?
While average ratios, as well as those considered “good” and “bad”, can vary substantially from sector to sector, a return on equity ratio of 15% to 20% is usually considered good. At 5%, the ratio would be considered low.
How do you calculate and analyze return on equity when total equity is negative?
Unlike other ratios, such as the return on assets ratio, the denominator of the return on equity ratio, that is to say the shareholders’ equity, can be negative.
This means that a positive ratio can actually be misleading.
For example, let’s assume a company has equity of -$1,000,000 and negative after-tax earnings of -$100,000.
“The ratio will then be positive, since we are dividing one negative number by another. We might think at first glance that everything is going well, but it’s not. The person conducting the analysis is responsible for checking whether the equity is negative,” says Nana.
If the denominator shareholders’ equity is negative, then the indicator should be interpreted in reverse; the lower the ratio, the better. A ratio of -12.5% is therefore better than a ratio of -5%.
What are the limits of return on equity?
The return on equity ratio only provides a rough idea of a company’s performance and financial health, explains Nana. For this reason, you should avoid limiting your analysis to the calculation of this ratio alone.
If ABC'S return on equity is 20%, while that of its competitor, XYZ, is 5%, we may at first consider ABC to be in a better financial position.
However, the return on equity does not provide information on debt. “The ratio shows that ABC generates a lot of revenue based on shareholder equity, but this may only be because it is over-leveraged,” says Dimitri Joël Nana.
To get a better overview, which would take into account the debt of both companies, we would have to calculate the return on total assets ratio.
Track your company’s performance
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