Return on equity measures the rate of return for ownership interest of common stock owners. It measures the efficiency of a firm at generating profits from each unit of shareholder equity, also known as net assets or assets minus liabilities. ROE shows how well a company uses investments to generate earnings growth. ROEs 15-20% are generally considered good.
Return on Equity or ROE is one of the ratios that can be used to measure the performance of an organization in terms of generating profits. It is commonly used to find the monetary efficiency of an organization. The ratio explains the strength of an organization to be able to use the available capital in order to generate income.
The common formula used for finding the ROE is as follows:
Return on Equity=(Net Income)/(Shareholder Equity)
Net income can be termed as the original profits of a company when all of the current expenses are subtracted from it such as taxes and salaries.
Shareholder equity is termed as the amount of net assets that are available for use to a company. This simply means that equity is the amount of assets minus the current liabilities of the organization.
Generally, an ROE of 15-20% is considered as excellent for a company. ROE however, is an industry specific ratio and it will not be wise to use company ROEs to compare companies present in different working industries.
There are few benefits of a high ROE if the net income is not reinvested in the business because the shares of a company with high ROE will simply be more expensive. Reinvesting major portions of the income, returns a small ROE, but improves company growth. The ROE factor is mostly prevalent for use in companies where reinvestment is a viable option.
The DuPont Formula is also quite useful in finding the strategic value of company profits. It breaks down ROE in terms of three different components. The first part is the net profit margin which is found by taking a ratio of net income with organizational sales. The second part is the assets turnover ratio. It is found by dividing sales with the total assets. The last part is the financial leverage which is found by the ratio of total available assets over the shareholder equity.
This formula covers all the situations and it is able to provide the true ROE in an organization that may be in debt or have other financial liabilities which it has to carry out, regardless of the way the business is going. This formula can be presented in the following manner:
DuPont ROE=(Net Income)/Sales×Sales/(Total Assets)×(Total Assets)/(Shareholders Equity)
Financial education is so important, but barely taught at all in our schools. Having resources online is great, but not if they are inaccessible to so many. Thanks 508!