What is Return on Equity (ROE)? -Definition
The return on equity ratio (ROE ratio) is calculated by expressing net profit attributable to ordinary shareholders as a percentage of the company’s equity. Equity of a company comprises of paid-up ordinary share capital, reserves and unappropriated profit. This represents the total interest of ordinary shareholders in the company.
This ratio shows how the management has been able to utilize the resources at its disposal. It is used to measure the profitability of the firm in relation to the amount invested by the shareholders.
Net profit attributable to ordinary shareholders is arrived at by deducting all prior claims (e.g. interest on long term loans, corporation tax and preference dividend) from the amount of net profit disclosed by profit and loss account of a company.
Equity for this purpose means only ordinary shares ( i.e., common stock), it does not include preferred shares. It is generally calculated by deducting total liabilities and preference equity from the total assets of the business.
Common equity = Total assets – (total liabilities + preference equity)
Average equity is arrived at by adding the equity at the beginning of the year to equity at the end of the year and dividing the total by 2.
Return on equity ratio calculated using the above formula is the ultimate test of the profitability of a company from the point of view of its ordinary shareholders (i.e., common stockholders). Therefore this ratio is typically known as return on ordinary shareholders’ equity or return on common stockholders’ equity ratio.
Return on total equity:
In practice, different versions of the return on equity ratio are used. For example, another popular variation of this ratio is to calculate the return on total equity i.e., ordinary shares plus preferred shares. In that case, the net profit before the deduction of dividends on preferred shares is used as numerator and the total of ordinary equity and preferred equity is used as denominator of the formula. The ratio calculated this way is typically known as return on total equity. Its formula is given below:
Note for students: As the figure of equity is not constant throughout the year, it is advisable to take the average equity figure. However, if average equity cannot be calculated from the available data (i.e., beginning equity is not given), the equity at the end of the period may be used as denominator.
The John Trading Concern provides you the following data at the year ended 2019:
Total assets: $2,400,000
Total liabilities: $1,076,000
8%Preference shares: $200,000
Net profit after tax: $240,000
Calculate return on common equity ratio and return on total equity ratio.
Return on common equity:
Return on common equity ratio = ($224,000*/$1,124,000**) × 100
*Profit to equity shareholders = Net profit after tax – Dividend on preference shares
= $240,000 – $16,000
**Equity of ordinary shareholders = Total assets – Total liabilities – Preference shares
= $2,400,000 – $1,076,000 – 200,000
Return on total equity:
Return on total equity ratio = ($240,000/$1,324,000*) × 100
*Equity = Total assets – Total liabilities
= $2,400,000 – $1,076,000