Blog #04 - Return On Equity

 

Return on Equity

In Blog #03 we read Return on Investment now we going to look at Return on Equity. In simple word equity is ownership in a company means shareholders have invested in that company. The profit that shareholder will get annually is called Return on Equity (RoE). RoE is classified into two types namely Return on Total Equity. Return on equity will tell you how much return did you get on equity capital but there are certain limitations of RoE. In fact in financial crisis of 2008-2009, many corporate manipulated RoE. Debt was used as tool to show good Return on Equity.

 

 

Debt affects the Stock Price of a company

 

Suppose you want to start a business then you have two ways by which you can raise capital one is equity and second one is debt. And also there are three ways to raise equity capital, these are initial amount (amount invested by owners/investors or partners), cash reserves and profit and last one is preferred equity which amount invested by strategic partners or they may be your friends or relatives. Preferred shareholders have priority. In mathematical way Capital = Equity share capital + Reserves & Surplus + Preferred equity + Debt. And in this if we combine equity share capital and reserves & surplus it becomes Common Equity. Common equity includes all the shares of a listed company on a stock exchange. Let understand this with an example. 

 

 

Suppose starting capital of business is 4 crore in which initial equity share value is 1 crore, 50 lakhs in reserves & surplus, preferred equity – 50 lakhs and a debt of 2 crore @ interest rate of 10% per annum. Let 15% return is to be given to preferred shareholders as per deal. Let see the income statement (example) of the company:

 

Income Statement

EBIT (operating profit): 80 lakh

Interest to be paid @10% : 20 lakh

PBT (Profit Before Tax) : 60 lakh

Tax @ 30% : 18 lakh

PAT (Profit After Tax) : 42 lakh (PAT is also called as Net Profit) 

 

 

Here we have to calculate RoE which will a ratio of two number and a ratio consist of numerator and a denominator. In our case denominator will be Equity and numerator may be EBIT, PBT or PAT. Now this will depend on the type of profit. In the calculation of Return on Equity we have to pay debt and tax first and then RoE will be calculated and according to this our numerator will be PAT (Profit After Tax). By this Return on Equity will be the ratio of PAT to Total Equity. RoE = PAT/Total Equity. In our example PAT is 42 lakhs and total equity is 100 lakhs + 50 lakhs + 50 lakhs  = 200 lakhs, so RoE will be 42 lakhs/200 lakhs which is equal to 0.21 or 21%.  Now this 21% return goes to equity share holders, preferred shareholders and in the company’s profit. 

 

Debt is to Equity Ratio should be negligible for a company health.

 

Let take a second situation, now suppose the company is listed then we have to calculate return on common equity. In this case our denominator will common equity instead of equity. In this case dividend or profit is to be paid after profit. So our numerator will be PAT – Preferred Dividends instead of PAT. So Return on Common Equity will be the ratio of PAT – Preferred Dividend divided by Common equity. If you calculated in our example Return on common Equity  will be 0.23 or 23%. Here RoE < Return on common equity.

Companies want to show maximum return to the investors. In the calculations made above PAT is natural way to increase return but instead of this companies start to decrease total equity and to decrease equity debt is to be increased which again leads to increased returns. Let see the capital structure for two companies in which structure 1 have 50% equity and 50% debt while structure 2 has 25% equity and 75% debt. Now assuming interest as same as previous case then we have following income statement of companies. 

 

	Structure 1 (figures in lakhs)	Structure 2 (figures in lakhs)
EBIT (operating profit)	80	80
Interest to be paid @10%	20	30
PBT (Profit Before Tax)	60	50
Tax @ 30% : 18 lakh	18	15
PAT (Profit After Tax)	42	35

 

If RoE for capital structure will be 35%, this is the situation when company scenario is good but you calculate same for bad economy (say EBIT = 2500000). The RoE in capital structure will be negative, it means your equity is eroding. THAT WHY EXCESSIVE DEBT CAN KILL COMPANIES IN TOUGH ECONOMIC ENVIRONMENTS,  whenever you going for investment always take a look at debt of the company whether it is negligible or big one. 

 

Return on Equity will never you full scenario you have to check Return on capital Employed also. That’s why you have to check all financial ratios deeply. Never rely on a single ratio.