Profitability Ratios

After reading this section, you will have been exposed to the different types of profitability ratios, their formulas, how to compute them, and which financial statements contain the information needed to calculate the ratios. You will also learn how to interpret the ratios and apply those interpretations to understanding the firm's activities.

Return on equity (ROE) measures how effective a company is at using its equity to generate income and is calculated by dividing net profit by total equity.

LEARNING OBJECTIVES

• Calculate the Return on Equity (ROE) for a business

• Describe what Return on Equity measures

KEY POINTS

• ROE is net income divided by total shareholders' equity.
• ROE is also the product of return on assets (ROA) and financial leverage.
• ROE shows how well a company uses investment funds to generate earnings growth. There is no standard for a good or bad ROE, but a higher ROE is better.

TERM

• equity

Ownership, especially in terms of net monetary value, of a business.

Return on Equity

Return on equity (ROE) is a financial ratio that measures how good a company is at generating profit.

ROE is the ratio of net income to equity. From the fundamental equation of accounting, we know that equity equals net assets minus net liabilities. Equity is the amount of ownership interest in the company, and is commonly referred to as shareholders' equity, shareholders' funds, or shareholders' capital.

In essence, ROE measures how efficient the company is at generating profits from the funds invested in it. A company with a high ROE does a good job of turning the capital invested in it into profit, and a company with a low ROE does a bad job. However, like many of the other ratios, there is no standard way to define a good ROE or a bad ROE. Higher ratios are better, but what counts as "good" varies by company, industry, and economic environment.

ROE can also be broken down into other components for easier use. ROE is the product of the net margin (profit margin), asset turnover, and financial leverage. Also note that the product of net margin and asset turnover is return on assets, so ROE is ROA times financial leverage.

$\mathrm{ROE}=\frac{\text { Net profit }}{\text { Sales }} \times \frac{\text { Sales }}{\text { Assets }} \times \frac{\text { Assets }}{\text { Equity }}$

Return on Equity: The return on equity is a ratio of net income to equity. It is a measure of how effective the equity is at generating income.

Breaking ROE into parts allows us to understand how and why it changes over time. For example, if the net margin increases, every sale brings in more money, resulting in a higher overall ROE. Similarly, if the asset turnover increases, the firm generates more sales for every unit of assets owned, again resulting in a higher overall ROE. Finally, increasing financial leverage means that the firm uses more debt financing relative to equity financing. Interest payments to creditors are tax deductible, but dividend payments to shareholders are not. Thus, a higher proportion of debt in the firm's capital structure leads to higher ROE. Financial leverage benefits diminish as the risk of defaulting on interest payments increases. So if the firm takes on too much debt, the cost of debt rises as creditors demand a higher risk premium, and ROE decreases. Increased debt will make a positive contribution to a firm's ROE only if the matching return on assets (ROA) of that debt exceeds the interest rate on the debt.