Return on equity (ROE)

Return on equity (ROE) is a mathematical equation commonly used by financial analysts in various companies. In general, ROE measures how effectively a company uses its wealth and resources to generate profit. Analysts compare a company’s ROE to that of similar companies in the same industry to estimate the overall efficiency of that company and attempt to find and solve any problems in how that company is operated.

Background

Throughout the long history of business, the main function of companies has been to generate a profit. In the most general sense, profit occurs when a company makes more money than it spends. Profit may seem like a straightforward figure, but calculating profit can be a complicated task, particularly in large businesses.

Businesses may have several kinds of income. They may make money by a wide variety of methods, including selling goods and services to consumers, selling stock to investors, making investments, or even buying and selling other companies. Businesses may have existing funds as well, including the investments of their own shareholders, or the group of people who own the parts of the company, and various holdings of funds, investments, or property.

However, at the same time, companies may have many forms of debt and expense that can draw from their total profits and holdings. Companies must pay their employees and cover all the operating expenses involved in whatever industry they are in, such as building factories, buying machines, providing fuel and raw materials, delivering goods, and so on. Companies may have borrowed funds from banks, the government, or even other companies that they must repay. They must also ensure that their shareholders are satisfied and that shareholder funds are safe, and pay applicable taxes and fees.

Because of these and many other factors, calculating profit can be challenging. The gross, or total, income does not show the whole picture. Rather, a variety of debts and expenses must be removed from the gross figure to reach the net income, or the amount earned after all deductions have been made.

Overview

Profits are extremely important to most companies, so calculating them accurately is of the utmost importance. Companies that show high profits not only generate money for all their employees, shareholders, and other members and associates; they also regularly attract attention and praise that may help to build their company profile and consumer base. Calculations of profit—even net profit—do not always show the complete picture of a company’s success, efficiency, or overall health, however.

A company may be making a tremendous quantity of money but still be inefficient and, in a certain since, much less successful than it could be. For example, a company may report a yearly net income of $10 million. By most standards, that figure would seem to indicate a successful and highly effective company. However, if that company is using a billion dollars worth of wealth and resources—such as international investments, global factories, high-level multimedia advertising, and massive distribution networks—the figure of $10 million suddenly seems quite small in comparison. Shareholders would likely be displeased that the vast wealth and resources of the company are yielding such a proportionately small amount of income.

For this reason, net profits are usually not the final measure of a company’s success. Financial analysts employ many other calculations to determine and examine how a company is faring. In the interest of comparing wealth versus income, the calculation known as return on equity (ROE) becomes one of the most crucial figures for companies. ROE is a figure in the form of a percentage that rates how effectively a company is using its various assets—wealth and resources in all forms—to generate profit.

Calculating ROE is a multistep process unique to each company. However, in general, it requires two figures. The first, net income, includes all the money earned in a given period minus the expenses incurred during that period. The second is shareholders’ equity, which gives a bigger picture of the company’s overall health and status beyond just the period in question. Shareholders’ equity is calculated by adding all of the company's assets and subtracting all of its debts. Once these figures are attained, analysts calculate ROE by dividing the net income by the shareholders’ equity. The resulting figure, therefore, plainly shows how well company leaders are using their assets to make more money.

Once calculated, the ROE has significant importance to a company for several reasons. The first and main reason is to gauge the overall effectiveness of the company. There is no formalized chart of good or bad ROE performance, though. Instead, judgment of ROE is unique to each company in each industry. Industries may yield different levels of ROE, so companies generally judge themselves in comparison to their peers in their industry. They generally strive to meet an average or above-average level of ROE within their industry norms.

For example, some industries have a huge amount of assets, such as utility companies that use massive generators and expensive power grids, and traditionally make modest income compared to their assets. Other industries, such as the corporate software industry, may have minimal assets yet turn out proportionally huge profits. In some cases, a single worker at a single computer may create a product worth millions of dollars. Because of this disparity between industries, the ROE of a utility company might seem extremely low compared to that of a software company, but might still be extremely high compared to less-efficient utility companies.

ROE is also vital to many companies for analyzing the ups and downs of their performance in a given period. Analysts often use ROE calculations to identify and correct problems within the company structure and policies. ROE is not a perfect indicator, and sometimes, companies with a high ROE may still have serious problems. For example, an ROE does not give a full picture of company health because a company may have several unprofitable years and then one good year. The ROE for that good year, therefore, does not necessarily represent a consistently successful company.

Bibliography

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