Alright, here we go with another ratio, Return On Equity. So return on equity, this is an important one here. It measures the income a company earns based on the amount of stockholders' equity, the return on the equity. Alright? So return on equity, this is a common profitability ratio. Right? And remember, that our investors want to maximize their return. Right? They want to get as much money out of it as they can out of their investment, right? So they want a really high return on equity. So return on equity, look at our formula here. Another pretty simple formula. We've got net income in our numerator. We're always going to be able to find that. Net income divided by our average common equity. Alright? This is important. Common equity. Remember that there could be preferred stock in the company and we've got to take that out. Okay? So we're gonna have a total amount of equity, which is total stockholders' equity, and if there's anything that belongs to the preferred shareholders, well, we've got to take that out. Right? Because preferred shareholders, well they're going to get paid first and then everything that's left over belongs to the common stockholders. Alright? So anytime you see this, we've got to get rid of the preferred shareholder stuff. A lot of times, they are not going to talk about preferred and common. They are just going to give you stockholders' equity. And that's what you're going to use. Alright? And the last thing about it is that we're using the average, right? I wouldn't expect you to have to deal with preferred shares and an average calculation all in the same question. It doesn't get so complicated in this class. But remember with the average, it's always calculated as the beginning balance plus the ending balance, divided by 2. Okay. So remember, every time we deal with that beginning balance plus ending balance divided by 2. Regardless of what account we're talking about here. Here, we're talking about common equity. Alright? So net income divided by average common equity, that's how we calculate our return on equity. And, oh, yeah. One more thing is that this is usually shown as a percentage, right? We're gonna show the percentage return on equity. So it'll be 5%, 10% return on equity. Right? So how do we analyze? What does this mean? What does this ratio tell us? Well, it tells us how much net income, right? Remember, with ratios it's always how much of the numerator per one of the denominator. So how much net income for each dollar of common equity. So for each dollar in the denominator, each dollar of common equity, how much net income does that dollar get, right? And that's why it's important to investors, right? They are the common equity. So how do we use this to compare? Well, the ROE, it depends on the breakup of its financing between debt and equity. Right? What does that mean? The finance between debt and equity? Well, imagine, remember our let me write it here. Our equation, assets equal liabilities plus equity, right? This liabilities plus equity, this is how we finance our assets, right? We're either gonna finance the assets that we own, we're gonna finance it with debt or with equity. So you can imagine if we have a lot of debt and just a little bit of equity. Well, when we make money, there's only a little bit of equity to split that with. So they're gonna get a bigger chunk of that money, right? So these highly levered companies, companies with a lot of debt, they're riskier, right? Because they have a lot of debt, so they have interest payments to make and they have debt liabilities that they have to repay. But if they're able to make money, it's gonna be bigger returns for the investors, right? So this is that high risk, high reward situation. When they're highly levered and have a lot of debt, they can make a lot of money for their shareholders. Because in essence, the amount of assets, right? They're mostly financed by debt which the the debt holders are they're going to get their money, whatever it is. But if you can make a lot of money off of that, the equity holders are going to get everything that's left over, Right? They get all the spoils. So if there's a lot left over, well there's only a few equity holders to share that with, and you get a bigger return. So high risk, high reward when you're highly levered company. Cool? So red flag we can run into here is that we can have a negative return on equity, right? That doesn't sound good to investors. That's negative money. Well, how could we have that? That's when we have a net loss, right? We can have negative common equity usually that that would be a weird situation. Maybe we've had a lot of net losses in the past and have a lot of retained, negative retained earnings or something. That's not very common. But we could have negative income, right? We can have a net loss during the period and that would be a not a return on equity, right? That would be a loss for the investors. We would have a negative return on equity, right? So that's how we calculate it here. Why don't we jump into some practice problems and try and calculate our return on equity. Let's do that now.
Ratios: Return on Equity (ROE): Study with Video Lessons, Practice Problems & Examples
Created using AIReturn on Equity (ROE) is a key profitability ratio that measures a company's net income relative to its average common equity. The formula is . A high ROE indicates effective management and maximized returns for investors, while a negative ROE signals potential losses. Understanding ROE helps assess a company's financial health and risk, particularly in relation to its debt levels.
Ratios: Return on Equity (ROE)
Video transcript
XYZ Company had net sales during the period of $380,000 and net income of $60,000. If total equity was $480,000 at the beginning of the period and $720,000 at the end of the period, what is the company's ROE?
A company has income before taxes of $100,000. Net sales are $400,000 and gross profit is $300,000. What is the ROE, assuming the company has a 40% tax rate, and average common equity was $900,000?
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What is Return on Equity (ROE) and why is it important?
Return on Equity (ROE) is a key profitability ratio that measures a company's net income relative to its average common equity. The formula for ROE is:
A high ROE indicates effective management and maximized returns for investors, while a negative ROE signals potential losses. ROE is important because it helps investors assess a company's financial health and efficiency in generating profits from shareholders' equity. It also provides insights into how well a company is utilizing its equity base to generate earnings.
Created using AIHow do you calculate Return on Equity (ROE)?
To calculate Return on Equity (ROE), you use the following formula:
First, find the net income from the company's income statement. Then, calculate the average common equity by adding the beginning and ending common equity balances and dividing by two:
Finally, divide the net income by the average common equity to get the ROE, usually expressed as a percentage.
Created using AIWhat does a high Return on Equity (ROE) indicate?
A high Return on Equity (ROE) indicates that a company is effectively managing its resources to generate substantial profits from its shareholders' equity. It suggests that the company is efficient in utilizing its equity base to produce earnings, which is a positive sign for investors. High ROE can also imply that the company has a competitive advantage, strong management, and good financial health. However, it's important to compare ROE with industry averages and consider the company's debt levels, as high leverage can artificially inflate ROE.
Created using AIWhat are the limitations of using Return on Equity (ROE) as a financial metric?
While Return on Equity (ROE) is a useful profitability metric, it has several limitations. First, ROE can be artificially inflated by high levels of debt, as leverage increases the returns on equity. Second, ROE does not account for the risk associated with high debt levels, which can lead to financial instability. Third, ROE focuses only on equity and ignores other important aspects of a company's financial health, such as liquidity and operational efficiency. Lastly, ROE can be affected by accounting practices and one-time events, making it less reliable for long-term performance assessment.
Created using AIHow does debt impact Return on Equity (ROE)?
Debt can significantly impact Return on Equity (ROE). When a company uses debt to finance its operations, it increases its leverage. High leverage means that a company has more debt relative to its equity. If the company generates substantial profits, the returns are distributed among fewer equity holders, resulting in a higher ROE. However, this also increases financial risk, as the company must meet its debt obligations regardless of its profitability. Therefore, while debt can boost ROE, it also introduces higher risk and potential financial instability.
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