Q. 4. Explain Return on equity capital with examples

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 paid8,00,000
12% 5,000 preference shares of 50each2,50,000
Profit before tax4,00,000
Rate of tax50%

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.

Also Check:  Control Ratios

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.

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