Return on Equity Ratio
Return on Equity Ratio (ROE RATIO) : Friends, in this Article, we will discuss about return on equity ratio. If you want to know what are financial ratios and how they help investors to measure the performance of a company, please make sure to read the previous article of this financial ratios.
Where we have discussed about basics of financial ratios and spoke about debt to equity ratio, as well.
ROE Ratio (Return on Equity Ratio)
Now we will talk about second ratio, which is called return on equity, ROE It’s a profitability ratio. This ratio tells you that how much profit a company is generating per unit of shareholder’s equity. So as we have discussed about debt financing, in the last ratio, debt to equity ratio; company can fund its operation using debt also and equity also.
This ratio tells you how much profit it is generating on the equity it has used. Now This ratio varies from industry to industry. And again it’s important for you to see that how this ratio is varying from company to company in a particular industry to better gauge the business of that industry.
The second point here is if this ratio is increasing over the past 3-4-5 years, it tells you to how effectively management of the company is deploying its equity into its business operations. It means how efficiently the management is investing into its assets or business. And the better he invests, more will be the productive assets, more will be the profit generated for the company.
Whereas if the ratio is declining over the previous 3-4 years, it tells you management of company is not effective in deploying equity into its assets. How much effective the management is and it’s investing money into such assets or operations which are not increasing profits productively over the past 3-4 years.
So you will see this ratio in a declining trend. But here one important. Let me explain you this through an example that how a company can boost its ROE.
How the boost of ROE Ratio
Which is, generally, using debt financing. Let’s understand through an example. Let’s consider total assets of the company are financed by equity which is Rs. 100. So, on this Rs. 100, if the company made total net profit of Rs. 10 in a financial year. This means ROE will be calculated as 10 divided by 100 which is 10%. It’s very simple.
Now let’s consider, in this case only, out of total assets of Rs. 100, it took Rs. 50 debt and Rs. 50 is financed by equity. Here, Debt to equity ratio becomes 1:1. 50 by 50. Now, let’s say, it took debt at 5% from any bank or whatever. Now, this means that 2.5 rupees which is 5% of Rs. 50 is the debt obligation which the company has to repay at the end of the year.
Now, if we talk about profits here, profit of Rs.10, which we have made in the first case where it was entirely equity financing. But in this case, profit will be decreased by Rs. 2.5. So here 10-2.5 = Rs. 7.5 will be your net profit. Now, if we calculate return on equity, it will be 7.5 divided by 50. You cannot divide it by 100 because equity finance in this case is only 50.
You have taken 50 through debt. So. this 7.5/50 boosts your ROE to 15%. So, friends, you have seen here that how just by mixing debt and financing the operations, still the total asset size in both the cases was same, but just because I have financed through debt, my ROE automatically boosted to 15% from 10%. Let’s take an example here of Reliance Industries.
ROE of Reliance Industries is around 10% and industry where Reliance works, average of that industry is 15-16%. So if you measure ROE, you will see. If you only see that ROE figure of Reliance is less than industry, you will say Reliance is not a good company.
Because ROE is 10% versus industry which is 16%. But we have seen in the last ratio, how debt to equity ratio of Reliance was 40% as compared to industry of 60%. So, here, Reliance uses less debt as compared to its competitors. So maybe it’s ROE is less because it has not used much debt financing to fund its business and its operations.
So this could be one of the reasons why Reliance’s ROE is less than its industry. Friends, today we discussed return on equity ratio. In the next we will tell you about dividend yield ratio, PE Ratio and free cash flow to sales ratio. Make sure to follow on Google News, to get the notification as soon as our next article arrives.