The return on equity ratio is an important ratio, which is calculated by businesses and shareholders to measure the profitability of a business enterprise.
Explaining the Equity Ratio
Like I mentioned before, it is a profitability ratio. What does that mean? Now by simply looking at the profit figure of the company in isolation, you will not be able to decide whether it is a good profit or not. Why? Because the profit of a company must be commensurate with the amount of capital invested.
Let me explain with the help of an example. On one hand you have a kid selling lemonade and on the other, a multinational company. Now if the kid makes a profit of $20, it would be a big deal, but a multinational booking the same $20 profit would be ridiculous. Similarly, it is quite impossible for a 7 year-old on a lemonade stall to pocket $1 million in profit.
Perhaps this comparison is far-fetched, but the bottom line should be noted here. The profit of the company in isolation, will not give the shareholders a good enough idea about the financial health of the company. To make the profit number seem a bit more relevant, it should be compared to another quantity, another number.
Now it is understandable that a company which starts its operations with a large capital should be able to leverage the benefits which the capital figure will have, and book a larger profit. This may not be so each time, but it is a fair assumption. A company with more capital will have larger operations, more sales and therefore, more profit.
Besides, the more the capital, the more is the number of shareholders that the company needs to pay dividends to anyway. So the profit they book needs to be substantially more than a company with lower capital, so that the shareholders get adequate return on investment. Thus, we can see that comparing profit with the capital invested by the company, will give a better understanding of how a company is really doing, and whether all the shareholders are getting the required return on their investment.
Return on Equity Ratio
Before we learn how to calculate return on equity, we must first see what are the variables we need. To calculate return on equity, we need to first find out two amounts. First is the net profit after tax (NPAT). The NPAT is the amount that the company is left with, after making all the relevant payments towards business expenses. In a way it is the distributable profit of the company. It is quite obvious that we choose to take this number to calculate return on equity, after all, the profits will be distributed out of this amount.
The second amount we need is the amount of capital on which the profits are being distributed. Now the formula clearly says return on equity, so equity capital is the only form of capital which will be considered for the purpose of this formula. Equity capital is arrived at after deduction of the total liabilities of the company from the total assets.
The equity capital of the company is the owned capital of the company, unlike the debt capital, which is a liability. Finding these values will enable you to calculate your debt to equity ratio.
The formula for return on equity is:
Net Profit after Tax * 100
Return on equity is an important ratio in ratio analysis. Ratio analysis is basically a branch of management accounting. As we saw, that an amount looked at in isolation doesn't really give a good enough understanding of the financial position of the company. Hence, other ratios, similar to this one are used by managers to understand just how well their company is doing.
The return on equity is generally measured as a percentage. What is a good return on equity? People usually assume that a return on equity is good if it is above 12%. But this figure varies depending on how the stock market is doing overall i.e., in a boom time, 12% may seem too less, whereas, when the markets are falling, 12% seems unrealistically high. Hence, a simple thumb rule will tell you that if your return on equity is more than what the market is earning, then it is a good return on equity.