Return on Equity (ROE) – Explanation with Example

Return on Equity (ROE) is a key aspect in fundamental analysis. It is also very important to look at while evaluating a company.

Introduction

When a company is started, it can raise 2 types of capital. First is equity capital which includes promoter’s money and also shareholders money (if shares have been issued) and the second is debt capital which includes loans, borrowing, long term debt, etc. A company which generates more ROE than the cost of capital of its debt component, that is the rate of interest on the debt, is always good.

ROE is a measure of a company’s financial performance. It indicates the relationship between a company’s profit and the equity shareholder’s return. It shows how much profit a company generates with the money (capital) shareholders have invested.

The higher the ROE, the more efficient the company’s operations are at making use of those funds.

Formula

Return On Equity (ROE) = (Net Income ÷ Shareholders Equity) × 100

Example

Let’s consider that a business raises Rs. 1,000 crores of capital. Out of that Rs. 1,000 crores, Rs. 500 crores are through equity capital and Rs. 500 crores are through debt capital. After conducting all its business activities, if the business generates around Rs. 200 crores as profits, then this Rs. 200 crores become Earnings Before Interest and Taxes (EBIT). Let’s assume taxes as NIL for the sake of example and understanding the concept. So, Rs. 200 crores become the earnings from the business, out of which it will have to pay interests at 10% on its debt, which amounts to Rs. 50 crores. Thus, we get Rs, 150 crores as the net income of the business, which will go the equity shareholders (promoters, FII’s, DII’s, or whoever has given money to raise the capital while starting the business or whenever they have purchased the shares).

So, ROE of the company is,

ROE = (Net Income ÷ Shareholders Equity) × 100

= (150 ÷ 500) × 100

= 30%

The interest rate on the debt component of the business is 10% and it is generating 30% on its equity component. This means that the business is performing well and giving high returns to its equity shareholders. On the contrary, if the business generated only Rs. 75 crores as profits, the net income of the business would be Rs. 25 crores after deducting the Rs. 50 crores of interests on debt.

Then the ROE will be,

ROE = (Net Income ÷ Shareholders Equity) × 100

= (25 ÷ 500) × 100

= 5%

Here, the ROE is less than the rate of interest on debt. Generally debt-ridden companies have low ROE and are not performing well.

Therefore, cost of capital on debt more than the business’ returns is not a good sign.