Deciphering ROE: The formula for evaluating business profitability
Posted: Wed Dec 18, 2024 3:59 am
ROE stands for Return On Equity . It is a useful concept, but it should not be confused with other financial indicators to which it is related.
For an entrepreneur, understanding it is an important step. It helps you understand external financial reports, write your own, collaborate with different departments in your business and, above all, make better decisions .
Start of marked textTWEET IT! Do you know what your business's financial profitability is? Take note of how to calculate ROE.End of marked text
1) ROE: What does this financial indicator mean?
The first thing to be clear about is that ROE is a financial indicator of profitability . This involves relating the profits achieved to the resources used. Although there are other tokelau email list profitability ratios, what is intended in this case is to capture financial profitability.
The idea behind this is that, in one way or another, the owners of the company have money invested in it and expect to get something in return . Specifically:
They expect net profits . Part of them can be distributed in the form of dividends and, therefore, returned to the owners. The rest is retained and is supposed to contribute to increasing the value of the company and, therefore, the value of the stake that each owner has in it.
The net worth is left in the hands of the company . This is the value of the investments made by the company after deducting the debts that partly finance them. In short, it is the accounting value of what corresponds to the owners.
ROE relates net profits to the resources that owners have invested in the company.
2) Why is it relevant?
There are several reasons behind the popularity of ROE as a financial indicator :
It is very easy to calculate . Ultimately, it is a matter of taking two figures from the accounting records and dividing them. However, the difficulty lies in the fact that not everyone and under all circumstances takes the same figures. For example, some people take equity instead of net worth, use the figures from the previous year for net worth, look for a comparison before taxes, etc.
It is highly comparable . If you only start from the figures that appear in the accounting records, you can have the data for this financial indicator for a set of companies. You don't need to know anything that is not public.
It allows you to work with it in different ways . For example, you can take actual past figures, make projections of how it is supposed to be in the future or calculate your expectations for the coming times using statistical techniques.
It links the company's activity with the decisions of its owners . In theory, the ROE should be higher than the cost of capital of the equity. However, in practice, the ROE changes more quickly than the important decisions and, in addition, these are conditioned by expectations that collect extra-accounting information that is not reflected in the ROE.
There are several ways to relate it to other financial indicators . In particular, those that relate it to economic profitability stand out.
3) How ROE is calculated
In principle, it is as simple as following the ROE formula :
ROE=net profit/equity
It can be seen that, unlike many other financial indicators, it is based on purely accounting figures . The net worth is found at the top of the balance sheet and the net profit is the result of the year that shows the end of the profit and loss account .
In this regard, it is important to remember that, from a financial point of view, more attention is usually paid to data on cash flows (receipts and payments). The reason is that the latter do not depend on criteria, so they are less manipulable, and are easier to place in time.
Despite the simplicity of its calculation, it is best to relate it to other financial indicators. That is why it is useful to have tools such as Sage Active that allow you to easily access financial reports.
4) How is it different from ROA?
ROA stands for return on assets , also known as economic profitability . It relates profit before interest and taxes to total assets. Therefore, it attempts to separate the effect of financing. It can be understood as the product of the margin on sales by the turnover of assets. In other words, it will be higher the higher the margin with which you sell and the relationship between sales and the investments made to achieve them.
For an entrepreneur, understanding it is an important step. It helps you understand external financial reports, write your own, collaborate with different departments in your business and, above all, make better decisions .
Start of marked textTWEET IT! Do you know what your business's financial profitability is? Take note of how to calculate ROE.End of marked text
1) ROE: What does this financial indicator mean?
The first thing to be clear about is that ROE is a financial indicator of profitability . This involves relating the profits achieved to the resources used. Although there are other tokelau email list profitability ratios, what is intended in this case is to capture financial profitability.
The idea behind this is that, in one way or another, the owners of the company have money invested in it and expect to get something in return . Specifically:
They expect net profits . Part of them can be distributed in the form of dividends and, therefore, returned to the owners. The rest is retained and is supposed to contribute to increasing the value of the company and, therefore, the value of the stake that each owner has in it.
The net worth is left in the hands of the company . This is the value of the investments made by the company after deducting the debts that partly finance them. In short, it is the accounting value of what corresponds to the owners.
ROE relates net profits to the resources that owners have invested in the company.
2) Why is it relevant?
There are several reasons behind the popularity of ROE as a financial indicator :
It is very easy to calculate . Ultimately, it is a matter of taking two figures from the accounting records and dividing them. However, the difficulty lies in the fact that not everyone and under all circumstances takes the same figures. For example, some people take equity instead of net worth, use the figures from the previous year for net worth, look for a comparison before taxes, etc.
It is highly comparable . If you only start from the figures that appear in the accounting records, you can have the data for this financial indicator for a set of companies. You don't need to know anything that is not public.
It allows you to work with it in different ways . For example, you can take actual past figures, make projections of how it is supposed to be in the future or calculate your expectations for the coming times using statistical techniques.
It links the company's activity with the decisions of its owners . In theory, the ROE should be higher than the cost of capital of the equity. However, in practice, the ROE changes more quickly than the important decisions and, in addition, these are conditioned by expectations that collect extra-accounting information that is not reflected in the ROE.
There are several ways to relate it to other financial indicators . In particular, those that relate it to economic profitability stand out.
3) How ROE is calculated
In principle, it is as simple as following the ROE formula :
ROE=net profit/equity
It can be seen that, unlike many other financial indicators, it is based on purely accounting figures . The net worth is found at the top of the balance sheet and the net profit is the result of the year that shows the end of the profit and loss account .
In this regard, it is important to remember that, from a financial point of view, more attention is usually paid to data on cash flows (receipts and payments). The reason is that the latter do not depend on criteria, so they are less manipulable, and are easier to place in time.
Despite the simplicity of its calculation, it is best to relate it to other financial indicators. That is why it is useful to have tools such as Sage Active that allow you to easily access financial reports.
4) How is it different from ROA?
ROA stands for return on assets , also known as economic profitability . It relates profit before interest and taxes to total assets. Therefore, it attempts to separate the effect of financing. It can be understood as the product of the margin on sales by the turnover of assets. In other words, it will be higher the higher the margin with which you sell and the relationship between sales and the investments made to achieve them.