Last Updated on Nov 1, 2022 by Aradhana Gotur

Financial ratios are used to analyze the financial health, strength, and efficiency of a company. Investors use these ratios to gauge a company’s potential to generate income, calculate risk, and then make investment decisions accordingly.

Understanding a company’s financial statements (balance sheet, income statement, or cash flow) to arrive at a fair valuation can be complicated. In such a scenario, these ratios act as quick litmus tests, to check whether the company has solid financial fundamentals or not.
In this article, we look at the most widely-used financial ratio – Return on Equity and will understand ROE meaning, importance, implications, and a lot more.

## What is the Return On Equity ratio?

The return on equity ratio is a financial metric used to anticipate the growth of the company in the future. As the name suggests, the ratio evaluates the “return” generated by the company “on equity,” i.e., the shareholder’s capital. ROE explains the return generated on each rupee invested by the shareholder.  Also, the ROE is calculated by combining values from two different financial statements. To calculate the ROE, you require the net income and dividends paid from the income statement and the equity capital from the balance sheet.

The return on equity ratio can be considered as the industry’s standard measure. If the ROE of any company is higher than the peers of the same industry, then the company enjoys an advantage. Plus, a high ROE indicates strong financial strength and the ability to generate more income, which makes it a good stock to pick.

## Formula Explained:

As stated above, ROE indicates the ability of the company to generate profit by using the shareholder’s capital. To calculate the investment return, both the net income and the shareholder’s capital should be positive.

The equation of the formula is:

ROE = Net income – Dividend amount paid to the preference shareholders / Average shareholder’s equity.

Net Income = Gross income – expenses

Average Shareholder’s Equity = (Equity at the start of the year + equity at the end of the year) / 2

### Components of ROE

The net income of the company includes total income from operations, excluding net expenses and other taxes. Average shareholder’s equity is the median value of the total equity capital infused during the financial year.

Calculating the average of the shareholder’s equity is considered the best practice to remove the effect of any fluctuations in paid up capital during the financial year.

## How does ROE  affect companies’ growth?

One way to estimate a company’s future growth is to multiply the ROE with retention ratio, that is the percentage of net income the company retains to reinvest.

If two companies have similar ROE, but one retains a larger amount of net income and reinvests in the company’s future growth, it is likely the company with the higher retention ratio will enjoy a higher growth rate.

## How to interpret the return on equity? Explained with an example

Return on Equity is used by potential investors, lenders, and management to evaluate past performance and gauge future potential. Typically, a higher ROE is better, but sometimes, a high ROE can also mean rising debt.

To keep equity infusion low, and thus, ROE high, the company may borrow more debt. Thus, no ratio should be used in isolation to conclude a company’s performance. Also, parallelly check for the liabilities side on the balance sheet for any changes in the company’s debt burden.

However, barring these circumstances, typically a higher ROE is a green flag for investors. It indicates that the equity capital is in safe hands, and the company is using it to generate attractive returns. On the other hand, a lower ROE indicates that the company is not generating attractive returns, and the investor’s equity capital is being utilized to purchase unproductive or non-income generating assets.

## Let’s understand this better with an example:

Let us assume, XYZ, an auto-mobile company, has an ROE of 15%. At the same time, the industry average is 12%. That is, the average ROE of its peer companies is lesser than XYZ’s ROE. Therefore, investing in XYZ looks attractive, and indicates that XYZ’s management is using the equity capital productively.

Now, let’s say a chemical company, ABC has an ROE of 18%. And, the chemical industry’s average ROE is 20%. The ROE of ABC will be considered less efficient than XYZ, even when the ROE is higher than XYZ. In this case, we can see that the company is underperforming when compared with its industry peers.

## How to identify risk by using ROE?

Sometimes a very high ROE can be a red flag. It might mean that equity capital in the company is low, compared to the profit. So if you see an unconventionally high ROE, double-check to see if it’s due to high profits, and not due to low equity. Here are some parameters an analyst needs to consider while evaluating the risk associated with a company.

### Uncertain profits

Let us understand this with the help of an example. For instance, XYZ is a loss-making company that has been reporting losses for the past seven years. Then the net income for the company would be a negative figure. Let us assume that the company had a windfall situation and turned profitable. Due to the low base of the denominator, the company might report an extremely high ROE that year, as the net income will hold a positive value.

Therefore, investors should analyze the past ten year’s data points and then decide.

### Surplus Debt

Now, another reason for the extremely high ROE might be surplus debt.

Because the equity is calculated by deducting debts from assets, high debt might lower the equity capital and thus, increase the ROE. Moreover, there have been scenarios where the company artificially increased ROE to make it look more attractive to investors or lenders.

Consider a simple scenario where the company takes a huge amount of loan to buy back its shares. The earning per share and the equity infusion will increase sharply. However, the growth and the profits of the company will stay unaffected.

### Negative net income or Negative equity capital

Ideally, if the company is reporting losses in the books of accounts, then ROE should not be calculated. If it is calculated, the numbers would be negative.

Thus, when the ROE figure is too high or is negative, it is a sign of risk and should be investigated thoroughly.

## Conclusion

The return on equity ratio is one of the major financial metrics used to evaluate the financial health of any company. Still, ROE should not be the standalone parameter to analyze any company. Investors should always do their due diligence and consult professional financial advisors before deciding on any major investment decisions.

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