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Learn the toughest concepts covered in your Financial Accounting class with step-by-step video tutorials and practice problems.

14. Financial Statement Analysis

# Ratios: Return on Equity (ROE)

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Ratios: Return on Equity (ROE) 4m
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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 get into as much 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 got to take that out of the equity. 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 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 gotta get rid of the preferred shareholder stuff a lot of times, they're not going to talk about preferred and common, they're just going to give you stockholders equity, and that's what you're gonna 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. Remember with the average it's always calculated as the beginning balance plus the ending balance divided by two. Okay. So remember every time we deal with that beginning balance plus ending balance divided by two, 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 it 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 while the R. O. E. 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 uh 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 going to 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, 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 leveraged 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 there, mostly financed by debt which the, the debt holders are, they're gonna get their money whatever it is. But if you can make a lot of money off of that, the equity holders are gonna 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 a highly levered company. Cool. So a 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't 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 could 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 and we would have a negative return on equity. Right? So that's how we calculated here. Why don't we jump into some practice problems and try and calculate our return on equity? Let's do that now. Yeah.
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Problem

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?

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Problem

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? 