The return on equity formula is the most common profitability ratios used by equity shareholders to judge the effectiveness of their funds invested in a firm.
The return on equity formula is a key formula when determining how well a company can use shareholder money to grow the company. A company with a low return on equity may be using shareholders money inefficiently. We can come to the conclusion that the return on equity formula is a formula that aims to help the shareholders, not the company itself.
Return On Equity Formula
Net worth includes all contributions made by equity shareholders, including paid-up capital, reserves and surplus. Keep in mind that financing decisions made by management can affect RoE, for example, assume that companies A and B earn similar operating profits of $100 and have the same tax rate of 30%. Also assume that both the companies have employed capital of $1000. However, company A employs only equity and company B employs debt at 15% interest rate, and equity in the ratio of 3:7. The following table depicts the difference in RoE of both the companies based on these assumptions.
|Net Profit margin||70.00%||59.50%|
|Return on Equity||7.00%||8.50%|
In this case, even though both the companies have earned similar operating margins, company B has a higher return on equity, to the tune of 8.50%. This is due to the leverage used by company B. While B provides higher return on equity to shareholders, it is also riskier compared to A which carries no debt. Similarly, RoE is also influenced by the average cost of debt and tax rates.
Remember, the return on equity formula is often used by shareholders to determine how much money the company is making relative to the amount of shareholder equity.