Return on equity can increase as a result of an increase in which of the following ratios

The return on shareholders’ equity ratio shows how much money is returned to the owners as a percentage of the money they have invested or retained in the company. It is one of five calculations used to measure profitability. The others are: net profit margin ratio, gross profit margin ratio, return on common equity, and return on total assets.

Unlike the return on common equity ratio, the return on shareholders’ equity ratio accounts for all shares, common and preferred. It is calculated by dividing a company’s earnings after taxes (EAT) by the total shareholders’ equity, and multiplying the result by 100%.

The higher the percentage, the more money is being returned to investors. This ratio helps business owners and financing professionals determine a company’s financial health.

The return on shareholders’ equity ratio is typically used to track a company’s performance over time or to compare businesses within the same industry.

More about the return on shareholders’ equity ratio

From the income statement and balance sheet figures below, ABC Co.’s earnings after taxes are $20,000 and its total shareholders’ equity is $100,000. This makes its return on shareholders’ equity ratio:

($20,000 / $100,000) x 100% = 20%

This is a very healthy ratio.

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Source: Return on Equity (ROE) (wallstreetmojo.com)

ROE Formula

The formula of Return on Equity is stated below –

Return on Equity Formula = Net Income / Total Equity

Consider the following example of 2 companies having the same net income but different shareholder equity components.

The ROE arrived after applying the formula are given as under

If one were to notice, we could see that the net income earned by the companies is the same. However, they differ concerning the equity component.

Hence by looking at the example, we can understand that a higher ROE is always preferred as it indicates efficiency from the side of the management in generating higher profits from the given amount of capital.

Interpretation of Return on Equity

You can interpret ROE by expanding the ROE formula and using the Dupont ROE equation.

DuPont ROE = (Net Income / Net Sales) x ( Net Sales / Total Assets) x Total Assets / Total Equity

DuPont Return on Equity   = Profit Margin * Total Asset Turnover * Equity Multiplier

Now you can interpret that they all are different ratios. If you wonder how come we have concluded that if we multiply these three ratios, we will get a return on equity, here’s how we have concluded.

• Profit Margin = Net Income / Net Sales
• Total Asset Turnover = Net Sales / Average Total Assets (or Total Assets)
• Equity Multiplier = Total Assets / Total Equity

ROE is always useful. But those investors who want to find out the “why” behind the current ROE (high or low) need to use DuPont analysis to pinpoint where the actual problem lies and where the firm has done well.

In the DuPont model, we can look at three different ratios by comparing which they can conclude whether it’s wise for them to invest in the company.

For example, if an equity multiplier, if we find out that the firm is more dependent on the debt rather than equity, we may not invest in the company because that may become a risky investment.

On the other hand, using this DuPont model would be able to pare down the chances of losses by looking at profit margin and asset turnover and vice versa.

ROE Example

In this section, we will take two examples of Return on Equity. The first example is the easier one, and the second example would be a bit complex.

Let’s jump in and see the examples right away.

Example # 1

Let’s look at two firms, A and B. Both of these companies operate in the same apparel industry, and most astonishingly, both of their Return on Equity (ROE) is 45%. Let’s look at the following ratios of each company so that we can understand where the problem lies (or opportunity) –

Now let’s look at each of the firms and analyze.

For Firm A, the profit margin is great, i.e., 40% and financial leverage is also quite good, i.e., 4.00. But if we look at the total asset turnover, it’s much less. That means Firm A is not able to utilize its assets properly. But still, due to the other two factors, the Return on Equity is higher (0.40 * 0.30 * 5.00 = 0.60).

For Firm B, the profit margin is much lower, i.e., just 20%, and the financial leverage is very poor, i.e., 0.60. But the total asset turnover is 5.00. Thus, for higher asset turnover, Firm B has performed well in the overall sense of Return on Equity (0.20 * 5.00 * 0.60 = 0.60).

Now imagine what would happen if the investors would only look at the Return on Equity of both these firms, they would only see that the ROE is quite good for both firms. But after doing DuPont analysis, the investors would get the actual picture of both of these firms.

Example # 2

At the of the year, we have these details about two companies –

Now, if we directly calculate the ROE from the above information, we would get –

Using the DuPont Analysis, we would look at each of the components (three ratios) and find out the real picture of both of these companies.

Let’s calculate the profit margin first.

Now, let’s look at total asset turnover.

We will now calculate the last ratio, i.e., the companies’ financial leverage.

Using DuPont analysis, here’s the ROE for both of the companies.

If we compare each of the ratios, we will see a clear picture of each company. For Company X and Company Y, financial leverage is the strongest point. Both of them have a higher ratio in financial leverage. In the case of profit margin, both companies have a lesser profit margin, even less than 15%. The asset turnover of Company X is much better than Company Y. So when investors would use DuPont, they would be able to understand the critical points of the company before investing.

Calculate Return on Equity of Nestle

Let’s look at Nestle’s income statement and balance sheet, and then we will calculate the ROE and ROE using DuPont.

Consolidated income statement for the year ended 31st December 2014 & 2015

The consolidated balance sheet as of 31st December 2014 & 2015

Source: Nestle.com 

• ROE Formula = Net Income / Sales
• Return on Equity (2015) = 9467 / 63986 = 14.8%
• Return on Equity (2014) = 14904 / 71,884 = 20.7%

We would use DuPont analysis to calculate Return on Equity for 2014 and 2015.

As we noted above, the basic ROE formula and DuPont FormulaDuPont formula determines the return on equity (ROE), depicting the efficient utilization of shareholders' capital into the business for generating revenue. The formula is "Return on Equity (ROE) = Profit Margin * Total Asset Turnover * Leverage Factor".read more provide us with the same answer. However, DuPont analysis helps us analyze why there was an increase or decrease in ROE.

For example, for Nestle, Return on Equity decreased from 20.7% in 2014 to 14.8% in 2015. Why?

DuPont Analysis helps us find out the reasons.

We note that Nestle’s Profit Margin for 2014 was 16.3%; however, it was 10.7% in 2015. We note that this is a huge dip in profit margin.

Comparatively, if we look at other components of DuPont, we do not see such substantial differences.

We conclude that the decrease in profit margin has led to the reduction of ROE for Nestle.

Colgate’s ROE calculation

Now that we know how to calculate Return on Equity from Annual Filings, let us analyze the ROE of Colgate and identify reasons for its increase/decrease.

Below is a snapshot of the Colgate Ratio Analysis Excel Sheet. You can download this sheet from Ratio Analysis TutorialRatio analysis is the quantitative interpretation of the company's financial performance. It provides valuable information about the organization's profitability, solvency, operational efficiency and liquidity positions as represented by the financial statements.read more. Please note that in Colgate’s calculation of ROE, we have used Average Balance Sheet numbers (instead of year-end).

Colgate Return on Equity has remained healthy in the last 7-8 years. Between 2008 to 2013, ROE was around 90% on average.

In 2014, Return on Equity was at 126.4%, and in 2015, it jumped significantly to 327.2%.

It has happened despite a 34% decrease in Net Income in 2015. Return on Equity jumped significantly because of the decrease in Shareholders Equity in 2015. Shareholder’s equity decreased due toShare buyback refers to the repurchase of the company’s own outstanding shares from the open market using the accumulated funds of the company to decrease the outstanding shares in the company’s balance sheet. This is done either to increase the value of the existing shares or to prevent various shareholders from controlling the company.read more share buybackShare buyback refers to the repurchase of the company’s own outstanding shares from the open market using the accumulated funds of the company to decrease the outstanding shares in the company’s balance sheet. This is done either to increase the value of the existing shares or to prevent various shareholders from controlling the company.read more and accumulated losses that flow through the Shareholder’s Equity.

Colgate Dupont Return on Equity = (Net Income / Sales) x (Sales / Total Assets) x (Total Assets / Shareholder’s Equity). Please note that the Net Income is after the minority shareholder’s payment. Also, the shareholder’s equity consists of only the common shareholders of Colgate.

However, ROE has not shown a declining trend. It is increasing overall. It is because of the Equity Multiplier (total assets / total equity). The Equity Multiplier has shown a steady increase over the past five years and stands at 30x.

Limitations of ROE

• There are so many inputs to be fed. So if there is one error in the calculation, the whole thing would go wrong. Moreover, the source of information also needs to be reliable. The wrong calculation means a wrong interpretation.
• Seasonal factors should also be considered in terms of calculating the ratios. In the case of DuPont Analysis, the seasonal factors should be taken into account, which most of the time isn’t possible.

ROE Video

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