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Return on Equity                                                      

 

Objectives

• Calculate and interpret return on equity (ROE).

• Demonstrate an understanding of the factors that contribute to inconsistent definitions of “equity” and “return” when using ROE. 

• Calculate and interpret sustainable equity growth.

Topic Outline

• Return Ratios

• Return on Equity 

• Summary

Key Definitions

• Return Ratios - represent the company’s ability to generate returns to its shareholders.

• Return on Equity (ROE) - expresses the percentage of net income relative to stockholders’ equity or the rate of return on the money that equity investors have put into the business.

 

Return on Equity (ROE) provides a simple metric for evaluating investment returns. By comparing a company’s ROE to the industry’s average, something may be pinpointed about the company’s competitive advantage. ROE may also provide insight into how the company management is using financing from equity to grow the business.

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I. Return Ratios

1. Return ratios are financial metrics used to assess the efficiency and profitability of a company's operations and investments. These ratios measure how effectively a company generates returns for its investors and shareholders. Some common return ratios include:

1. Return on Investment (ROI)

2. Return on Equity (ROE)

3. Return on Assets (ROA)

4. Return on Capital Employed (ROCE)

5. Return on Invested Capital (ROIC)

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B. Business managers use return ratios to compare the returns generated on one investment with other potential investments.

C. Investors and Analysts also use return ratios to evaluate a company's performance, profitability, and overall financial health.

D. Return on Equity (ROE) measures the amount of profit in relation to common shareholders’ equity.

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II. Return on Equity

1. Return on Equity (ROE) is considered a gauge of a corporation’s profitability and how efficient it is in generating profits for its equity shareholders. The higher the ROE, the more efficient a company’s management is at generating income and growth.

2. ROE is the measure of a company’s annual return (net income) divided by the value of its total shareholders’ equity, expressed as a percentage. Alternatively, ROE can also be derived by dividing the firm’s dividend growth rate by its earnings retention rate (1 – dividend payout ratio). 

3. ROE combines information from both the income statement and the balance sheet by comparing a company's profit to the shareholders' equity.

4. The number represents the total return on equity capital and shows the firm’s ability to turn equity investments into profits. To put it another way, it measures the profits made for each dollar from shareholders’ equity.

5. The formula to calculate ROE is:

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Return on Equity Formula

The following is the ROE equation:

ROE = Net Income / Total Shareholders′ Equity× 100%

 

Example:

XYZ Inc. had a net income of $500,000 and total shareholders' equity of $2,000,000 for the year. To calculate the Return on Equity (ROE), the formula is applied as follows:

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Substituting the given values: 

ROE = $500,000​ / $2,000,000 × 100%

ROE = 0.25 / 1 × 100%

ROE =25%

Therefore, XYZ Inc.'s Return on Equity (ROE) for the period is 25%. This indicates that for every dollar of shareholders' equity invested in the company, it generates a profit of 25 cents.

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The DuPont Model is an expanded version of this basic ROE calculation. 

Formula: 

ROE =(Net IncomeAverage Total Assets) x (Average Total AssetsAverage Equity)

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Example:

For ABC Corp., with a net income of $800,000, and average total assets of $5,500,000, and average equity of $2,250,000, the Return on Equity (ROE) is calculated as follows:

ROE =($800,000 / $5,500,000) x ($5,500,000 / $2,250,000)

ROE =0.1455×2.4444

ROE =0.3559

Therefore, ABC Corp.'s Return on Equity (ROE) for the period is approximately 35.59%. This means that for every dollar of equity invested in the company, it generates a profit of about $0.36.

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III. Summary

1. Return ratios, including Return on Equity (ROE), Return on Assets (ROA), Return on Investment (ROI), Return on Capital Employed (ROCE), and Return on Invested Capital (ROIC), are essential financial metrics used by investors and analysts to evaluate a company's performance and profitability.

2. ROE offers a straightforward measure to assess investment returns. Comparing a company’s ROE with the industry average can reveal insights into its competitive edge. Additionally, ROE can shed light on how effectively management utilizes equity financing to foster business growth.

3. A consistent and rising ROE over time suggests a company's proficiency in enhancing shareholder value through prudent reinvestment of earnings, thereby boosting productivity and profits. Conversely, a diminishing ROE may indicate management's ineptitude in allocating capital to unproductive assets, leading to poor decisions.

4. Investors and managers must be careful when using the above formulas because there can be different meanings or definitions for assets, equity, and income. 

5. In all cases, the key to understanding ratios is to know what the analyst is using for the calculations and to make sure that the components of the calculations are consistently used. If not used consistently, then comparisons to other time 

 

 

Practice Questions

Part 1: Theories (5)

 

1. In analyzing Return on Equity (ROE), which of the following ways does the DuPont Model enhance the analysis of the ROE calculation?

A. It does not enhance the analysis of ROE calculations.

B. It measures operational efficiency, asset use efficiency, and financial leverage.

C. It measures operational leverage, asset use efficiency, and financial efficiency.

D. It measures how well the organization manages its assets at various levels of activity.
 

2. For a given level of sales, and holding all other financial statement items, including liabilities, constant, a company's return on equity (ROE) will:

A. Increase as their debt ratio decreases.

B. Increase as their equity increases.

C. Decrease as their total assets increase.

D. Decrease as their cost of goods sold as a percent of sales decrease.
 

3. According to the DuPont formula, which one of the following will not increase a profitable firm’s return on equity?

A. Lowering equity multiplier.

B. Increasing total asset turnover.

C. Increasing net profit margin.

D. Lowering corporate income taxes.
 

4. A corporation’s return on equity can be calculated if you know its

A. Market-to-book ratio and equity multiplier.

B. Sustainable equity growth rate and dividend payout ratio.

C. Debt-equity ratio and market-to-book ratio.

D. Dividend yield and earnings yield.

 

5. The DuPont formula involves which combination of financial elements in its computation?

A. Net profit margin, total asset turnover, and equity multiplier.

B. Total asset turnover, sales turnover, and equity multiplier.

C. Total asset turnover and sales turnover profitability.

D. Profit margin, sales turnover, and asset-use efficiency.

 

Part 2: Problem Solving (5)

 

1. Squidward Company has $1,000,000 in assets and owes $300,000. IfABC has sales of $10 million and a net profit margin of 5%, what is its return on equity (ROE)?

A. 42.9%.

B. 50%.

C. 71.4%.

D. 70%.

 

2. Financial statements from Simpson Inc. indicate the company has the following balances:

Current Assets (Beginning Balance)           $196,000

Plant and Intangible Assets (Beginning Balance) 568,000

Plant and Intangible Assets (Ending Balance) 568,000

Current Assets (Ending Balance) 210,000

Net Income 643,000

Common Stock 300,000

What were Simpson’s net sales if its asset turnover is 2.25 times?

A. $1,719,000

B. $1,659,375

C. $1,599,750

D. $675,000

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3. Mcvey Concrete has $1.2 million in assets that are currently financed with 100% equity. Mcvey's EBIT is $300,000 and its tax rate is 30%. If Mcvey changes its capital structure (recapitalizes) to include 40% debt, what is Mcvey's ROE before and after the change, respectively? Assume that the interest rate on debt is 5%.

A. 17.5%, 26.8%

B. 17.5%, 29.2%

C. 25.0%, 26.8%

D. 25.0%, 29.2%

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4. A company’s year-end selected financial data is shown below. 

   Year 2            Year 1 

Current assets              $250,000        $175,000 

Total assets                    600,000            500,000

Total liabilities                 300,000            225,000 

Net sales                        200,000            150,000 

Net income                       75,000              60,000 

The company’s rate of return on assets and rate of return on equity for Year 2 are:

A. 36% and 25%, respectively.

B. 13% and 25%, respectively.

C. 12% and 22%, respectively.

D. 14% and 26%, respectively.

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5. Evan Corp. had sales of $2,000,000, a profit margin of 11%, and assets of $2,500,000. Spear decided to reduce its debt ratio to 0.40 from 0.50 by selling new common stock and using the proceeds to repay principal on some outstanding long-term debt. After the refinancing, what is Evan’s return on equity (ROE)?

A. 5.3%

B. 3.5%

C. 22.9%

D. 14.7%

 

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Answer Key

Theories
 

1. B. It measures operational efficiency, asset use efficiency, and financial leverage.

Explanation: The Dupont Model formula for measuring ROE is: ROE = (Net Profit+Sales) x (Sales + Assets) x (Assets + Equity), whereas (Net Profit + Sales) measures operating efficiency, (Sales + Assets) measures asset use efficiency, and (Assets + Equity) measures financial leverage. The amounts used for Assets and Equity are typically assumed to be the average of the beginning and end of year values.
 

2. C. Decrease as their total assets increase.
Explanation:
To analyze ROE, use the DuPont model for ROI and multiply it by the leverage factor. This would appear as:

DuPont model ROI = Net Income = Sales x Sales + Average Assets Leverage factor = assets + equity

ROE = DuPont model ROI x Leverage factor

ROE = Net Income = Sales x Sales + Average Assets x Assets + Equity

All other things being equal, the ROE will decrease as total assets increase. ROE will decrease as the debt ratio decreases. As cost of goods sold as a percent of sales decreases, profit will increase along with ROE. As the level of equity increases, ROE will decrease.

 

3. A. Lowering equity multiplier.

Explanation: Lowering the equity multiplier would not increase a profitable firm’s return on equity. The DuPont model depicts return on assets as total asset turnover (sales divided by average total assets) times the profit margin (net income divided by sales).

 

4. B. Sustainable equity growth rate and dividend payout ratio.

Explanation: The sustainable equity growth rate can be found by multiplying return on equity by 1 minus the dividend payout ratio. Thus, the return on equity can be derived given the sustainable growth rate and the dividend payout ratio.

 

5. A. Net profit margin, total asset turnover, and equity multiplier.

Explanation: The DuPont model begins with the standard equation for return on equity (ROE) and breaks it down into three different efficiency components. ROE = Net profit margin × Asset turnover × Equity multiplier

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II. Problem Solving
 

1. C. 71.4%.

Explanation: ROE is net income divided by total equity. In this problem, equity (assets minus liabilities) is $1 million - $300,000 = $700,000. If the profit margin (net income divided by sales) is 5% and sales are $10 million, then net income must be $500,000. Therefore, ROE is $500,000 + $700,000 = 71.4%.
 

2. B. $1,659,375

Explanation: Asset turnover measures how much sales revenue a company generates per dollar in average total assets. Higher values are generally preferred as it shows the company is using its assets more efficiently to generate sales. It is defined as Net Sales + Average Total Assets. Rearranging the formula results in net sales being equal to Asset Turnover x Average Total Assets. Simpson's average total assets is $737,500 [($764,000 + $711,000) = 2]. This results in Simpson having net sales of $1,659,375 (2.25 x $737,500). Therefore, this is the correct answer.

 

3. A. 17.5%, 26.8%
 

 

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4. D. 14% and 26%, respectively.
Explanation: Return on assets equals net income divided by average total assets. The return on assets equals 14% {$75,000 ÷ [($600,000 + $500,000) ÷ 2]}. Return on equity equals net income divided by average total equity. Total equity equals total assets minus total liabilities. Thus, the return on equity equals 26% {$75,000 ÷ [($300,000 + $275,000) ÷ 2]}.


5. D. 14.7%
Explanation: The debt ratio equals total debt (liabilities) divided by total assets. Therefore, Evan’s total liabilities after the repayment of long-term debt are $1,000,000 ($2,500,000 total assets × 0.4 debt ratio). According to the basic accounting equation, assets equal liabilities plus equity. Thus, Evan’s equity equals $1,500,000 ($2,500,000 assets – $1,000,000 liabilities). ROE measures the amount of income a company earns per dollar invested by the equity holders. It equals net income divided by average amount of equity (or total equity based on the data provided in this question). Net income for the period is $220,000 ($2,000,000 sales × 11% profit margin). Therefore, the return on equity is 14.7% ($220,000 net income ÷ $1,500,000 equity).

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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References: 

 

CFI Team. (2023, November 23). Return on equity (ROE). Corporate Finance Institute. https://corporatefinanceinstitute.com/resources/accounting/what-is-return-on-equity-roe/
 

Gleim. (2022). Gleim CMA Review Part 2: Unit 2: Profitability and Per-Share Ratios
 

Vipond, T. (n.d.). Profitability Ratios. Corporate Finance Institute. https://corporatefinanceinstitute.com/resources/accounting/profitability-ratios/#:~:text=Return%20ratios%20represent%20the%20company's,and%20return%20on%20capital%20employed.
 

Wiley. (2023). Wiley CMA Exam Review 2023 Study Guide Part 2: Strategic Financial Management Set (1-year access). Wiley.