Answer
Return on equity capital
The equity shareholders are the real owners of the company. They bear all risk whereas preference shareholders have priority of payments of dividends and as well as capital. The rate of dividend on equity shares differs year to year, depending upon the amount of profit. The performance of a company is judged by the amount of return on equity capital.
Formula to calculate Return on equity capital
Return on equity capital = (N.P. after tax – Preference dividend) / Equity share capital
Example
| 10,000 shares of $100 each, $80 paid | 8,00,000 |
| 12% 5,000 preference shares of 50each | 2,50,000 |
| Profit before tax | 4,00,000 |
| Rate of tax | 50% |
Solution
ROE = (Net profit after tax – Preference dividend) x 100 / Equity share capital paid up
| Profit = | 4,00,000 |
| Less tax 50% = | 2,00,000 |
| Profit after tax = | 2,00,000 |
| Less preference dividend 12% (2,50,000) = | 30,000 |
| 1,70,000 |
ROE = 1,70,000 (N.P. after tax & preference dividend) x 100 / 8,00,000
= 21.25%
Comment: This ratio is most suitable to equity shareholders who want to know how much profits are earned by the company thus can be known how much dividend will be received by them.
Earning per share (EPS)
It is the short cut to the earning per shares here profit after tax and preference dividend is divided by number of shares.
Example
Taking the above details from Example 1:
EPS = 1,70,000 (N.P. after tax & Preference dividend) x 100 / Number of equity shares
= 1,70,000 / 10,000 = $17 per share
There is a good measure of profitability and for Comparing EPS of similar companies.
Current Assets movement or Efficiency activity Ratio
These ratios are also known as turn over ratios as these indicate the speed by which the assets are converted into sale. These ratios are calculated on sales.
Inventory turn over ratio = Cost of sales / Average Stock
Opening Stock = (Opening Stock + Closing stock) / 2
Example
Opening stock = $20,000
Closing stock = $10,000
Purchases = 50,000
Carriage on purhcases = 5,000
Sale = $1,00,000
Calculate Stock turn over ratio (STR) = Cost of goods sold / Average stock
Cost of goods sold = Opening stock + Purchase + Carriage – Closing stock
= 2,00,000 + 50,000 + 5,000 – 10,000 = 65,000
Average stock = (Opening stock + closing stock) / 2
= (20,000 + 10,000) / 2
= $15,000
Thus, Stock turn over ratio = 65,000 / 15,000 = 13:3
Comment: This ratio shows how many times stock is purchased during the year.