Return on Equity (ROE)

Definition; this is a gauge of efficiency of profitability from the point of view of the shareholders. It is also referred to as returns on the net worth or returns on the shareholders’ funds. The question being answered here is whether it is a worth course for the shareholders to have invested in the company by buying ordinary shares of the company.

NB: Remember that equity is all what the owners claim on a business and it entails retained earnings, general reserves, capital redemption reserve fund, ordinary share capital, share premium and any other common stock associated reserves.

Example

The following balance sheet was extracted from the books Hard Nut to Crack ltd for the year ended 31st/12/2017

Earnings after Taxation was $890,000

Required  

i)Determine Returns on Equity (ROE) for the period ended 31st/12/2017

ii) Interpret the results in (i) above

Solution

i)

ii). Interpretation; for every one unit currency of USD invested by the owners, it results to 0.3122 USD currency of income generated. Therefore, the management or the owner of the business need to be careful when deciding the investment assets to acquire.

OR

A 100% investment results to 31.22 % increase in returns.

Applicability of Return on Equity (ROE) and management decision making

ROE is expressed as

and as it is in ROA, the numerator factor is uncontrollable by the management. However, for the denominator, the management can ensure that the base for equity is big. This can be achieved by making decisions such as re-financing of the business by retaining the profits made at the end of the financial period.