Return-on-equity can be calculated on a per-share basis or on a whole figure basis.

On a per-share basis RoE is calculated by dividing Earnings Per Share, EPS, by Book Value. Earnings Per Share are calculated by dividing the Net Profit After Tax, NPAT, by the number of shares outstanding for the company. Book Value is the business Equity divided by the number of shares outstanding in it. It is also called Equity Per Share.

As an example, Qantas EPS are $0.398 while its Book Value is $3.12. RoE can be calculated as follows: 0.398/3.12*100 = 12.76%. Because RoE is a percentage figure if must by multiplied by 100.

On a whole figure basis, RoE is calculable by dividing NPAT by Equity.

To know how much Return-on-equity you should be demanding, RoE has been statistically found to be on average 12 per cent in the US. So, you could take that as a benchmark.

On the other hand, when appraising an investment decision, you should find out how much return alternative investments such as bank deposits or bonds are offering and compare it with your company's RoE.

There are other measures of profitability such as Return-on-capital, RoC. Since when you start a business you often use debt besides equity it makes sense to take that into account and find out how much the business is faring on that basis.

RoC is calculated by dividing NPAT by Equity plus Long-Term Debt multiplied by 100. RoC should be lower than RoE.

Still using Qantas as an example, NPAT is $719.4 million, Equity is $6189.1 million and Long-Term Debt is $4978.7 million. So, RoC is: 719.4/(6189.1+4978.7)*100 = 6.44%.

Another measure of profitability is Return-on-assets, RoA. This is especially important for businesses which have great asset requirements such as the automobile industry and manufacturing generally. RoA is calculated by dividing the NPAT by the Assets of the company and multiplying by 100.

The reader could find the information to seed these calculations from the websites of the companies in question. Just look for Corporate and download their latest Annual Report where you can find all the necessary financial information. Additionally, you could find the required financial data from online databases accessible through this and other websites.

 

After having found out about the Dividend the company pays, you would be interested in knowing the profit which the company has made which is available to the shareholder's. The company may use this profit to pay dividend or may retain this profit to grow the company. Most companies would pay a certain percentage of this profit as Dividend and utilize the balance portion for growth of the business. However this money which is utilized by the company belongs to the shareholders and is like a further investment which you have made in the company. The money which is retained by the business is carried forward to the Balance Sheet as Retained Earnings (after making provisions for certain statutory reserves which may be required).

The net income or profit which is available to the shareholder's to the Shareholder's Fund is known as the Return on Equity (ROE). In simple words it states the profit which the company has made from the investments made by the shareholders.

Formula

Return on Equity (ROE) = Net Income / Shareholder's Equity

ROE is also known as Return on Shareholder's Funds or Return on Net Worth. The result from the above formula is expressed as a percentage.

Net Income is the Net Profit which the company has earned during the period. It is the Profit After Tax which is available for distribution to the shareholder's. The Net Income is usually considered after deducting the preferred dividend, since the ROE is mostly calculated on common equity.

Shareholder's Equity includes Share Capital, any reserves which are required to be created and Retained Earnings. It is also known as Net Worth i.e. Total Assets minus Total Liabilities. In case ROE is calculated for common shareholder's preferred equity is deducted which is usually the case. ROE can also be calculated by taking the Average Capital i.e. Opening Capital plus Closing Capital divided by 2.

Example

Profit And Loss Account (Relevant Figures)

Revenue - $ 100,000

Total Costs - $ 90,000

Profit Before Tax - $ 10,000

Tax - $ 2,000

Profit After Tax - $ 8,000

Balance Sheet (Relevant Figures)

Assets

Fixed Assets - $ 75,000

Current Assets - $ 75,000

Total Assets - $ 150,000

Equity

Capital and Reserves

Share Capital - $ 50,000

Retained Earnings - $ 30,000

Liabilities

Long Term Loans - $ 20,000

Current Liabilities - $ 50,000

Total equity and liabilities - $ 150,000

Return on Equity (ROE) = Net Income / Shareholder's Funds

ROE = 8000 / (50,000 + 30,000)

ROE = 10%

Commentary

In the example above ROE is 10% which is reasonable. ROE of some of the best companies usually averages 10% to 20%. ROE of 15% is normally considered to be good for most industries. ROE below 5% requires improvement. If ROE is above 20% it is remarkable, however very difficult to sustain.

Like most ratios it is important to compare ROE calculated with other companies in the same industry.

There are various definitions of the term Return and Capital Employed. These are explained with the help of formulas and examples.

Formula:

ROCE = (EBIT / (Total Assets - Current Liabilities)) * 100

OR

ROCE = (EBIT / Capital Employed) * 100

Explanation of the Numerator and Denominator

EBIT = Earnings Before Interest and Tax also known as Operating Profit.

In certain cases the numerator used is Profit Before Tax. However in most cases EBIT is used as the numerator which seems to be more correct. Profit Before Tax is mainly used to calculate Return On Equity.

Capital Employed = Shareholder's Funds + Long Term Borrowings.

In other words Capital Employed is Total Assets - Current Liabilities, which is also used as the Denominator.

There are different definitions of the term Capital Employed. Thus in some cases it is defined as Total Assets.

In other cases instead of Long Term Borrowing, Total Borrowings are considered. Total Borrowings would include overdraft, short term loans and lease obligations.

Thus, in the formula above current liabilities can also be replaced by non-interest bearing liabilities.

Whether to include Total Borrowings or Long Term Borrowings would depend on the materiality of the value of overdrafts and other interest bearing short term liabilities. Thus if the value of overdraft and other short term borrowings is less then it can be ignored. This also depends on how you interpret the ratio and can be decided on a case to case basis. It is wise to include all Borrowings / Interest bearing liabilities as Capital Employed since EBIT is used in the numerator. Thus the intention is to know the return which is sufficient to bear the interest cost to maximize the shareholder's earnings.

Example 1

Profit and Loss Account for the year ended 31-12-07 (Only Relevant Figures)

Sales - $ 75,000

Operating Profit (EBIT) - $ 15,000

Interest - $ 1,800

Profit Before Tax (PBT) - $ 13,200

Balance Sheet as at 31-12-07

Fixed Assets - $ 125,000

Current Assets - $ 75,000

Total Assets - $ 200,000

Share Capital - $ 100,000

Reserves - $ 25,000

Long Term Loans - $ 25,000

Current Liabilities - $ 50,000

Total Liabilities - $ 200,000

ROCE = (EBIT / Capital Employed) * 100

ROCE = (15,000 / (100,000 + 25,000 + 25,000) * 100

ROCE = 10%

OR

ROCE = (EBIT / (Total Assets - Current Liabilities)) * 100

ROCE = (15,000 / (200,000 - 50,000)) * 100

ROCE = 10%

The ROCE needs to be compared with the Rate of Interest on Bank Borrowings which in this case is between 7% to 8%. Thus any increase in Bank Borrowings with proportionate business growth would still leave a share of 2% to 3% for the shareholders if ROCE is maintained at 10%.

Example 2

Profit and Loss Account for the year ended 31-12-07 (Only Relevant Figures)

Sales - $ 125,000

Operating Profit (EBIT) - $ 20,000

Interest - $ 15,000

Profit Before Tax (PBT) - $ 5,000

Balance Sheet as at 31-12-07

Fixed Assets - $ 175,000

Current Assets - $ 150,000

Total Assets - $ 325,000

Share Capital - $ 75,000

Reserves - $ 25,000

Long Term Loans - $ 100,000

Current Liabilities

Creditors - $ 50,000

Bank Overdraft - $ 75,000

Total Liabilities - $ 325,000

Calculation of ROCE without considering Bank Overdraft

ROCE = (EBIT / Capital Employed) * 100

ROCE = (20,000 / (75,000 + 25,000 + 100,000)) * 100

ROCE = 10%

OR

ROCE = (EBIT / (Total Assets - Current Liabilities)) * 100

ROCE = (20,000 / (325,000 - 125,000)) * 100

ROCE = 10%

Calculation of ROCE considering Bank Overdraft

ROCE = (EBIT / Capital Employed) * 100

ROCE = (20,000 / (75,000 + 25,000 + 100,000 + 75,000)) * 100

ROCE = 7.3%

OR

ROCE = (EBIT / (Total Assets - Non interest bearing liabilities)) * 100

ROCE = (20,000 / (325,000 - 50,000)) * 100

ROCE = 7.3%

The interest rate charged by the Bank is between 8% to 9%. In this case it is better to consider Bank Overdraft in the ROCE calculation, since it gives a more realistic figure of 7.3% on the Capital Employed. Thus any increase in Bank Borrowings either Long Term Loans or Bank Overdraft is going to affect the Shareholder's earnings. It may result in reduction of Shareholder Earnings in case the EBIT growth is proportionate to the growth of Capital Employed when the increase in Capital Employed is mainly by way of increase in Borrowings.

One factor which needs to be considered here is whether there is a sudden increase in the Bank Overdraft towards the end of the Accounting Period for which the ROCE is calculated. If this is the case then it is better to consider the annual average, instead of the year end value. If the annual average is not material then it can be ignored. One way of determining whether the Bank Overdraft is of significant value or not during the year is to analyze the interest (finance cost) incurred during the year and the rate of interest charged by the Bank. In case the interest on the Long Term Borrowings is approximately close to the total interest (finance cost) then it can be assumed that the Bank Overdraft value is not material.

Conclusion

ROCE gives us an indication of how the company is utilizing its capital and whether the company is making enough earnings to cover its cost of capital. The ROCE needs to be compared with other companies in the industry since certain companies are capital intensive and thus may have a lower ROCE.

ROCE also needs to be compared with the interest earned from the Bank. In case interest earned %age is higher than management could consider investing the money in the Bank instead of investing in business.

ROCE earned from one business or one project can be compared with other business / project to increase the investment in the business which gives the best ROCE.