How To Calculate ROE
How To Calculate ROE
In investing, you need to know how well a company is performing. One calculation for that would be the return on equity.
Hi, my name is Grant Hobson. I work as a finance analyst, and today I'm going to talk you through some business maths, calculations and ratios. How to calculate return on equity.
The return on equity calculation simply shows the amount of income that is returned from the money invested in the company. It's a measure of the profitability and what we're doing with the money that gets invested and it should be used in conjunction with several of financial performance measures to establish how well a company is performing. We're going to run through an example now, but before we do, we'll just say that a company with, say 25%, 30% return on equity's deemed to be performing really well, whereas if you're below 5%, then it's deemed to be a bad performance.
That's all these two extremes that we look at. So, I'll run through the examples now to demonstrate this. So, in terms of the formulas that we're going to need to complete the calculation, the formula one will be return on equity calculation.
It's simply the net income divided by shareholder's equity. To calculate shareholder's equity, you just need to know that it's total assets minus total liabilities. So, we'll be using both the income statement on the balance sheet.
So, get your figures first calculation. We take our example one, we're going to look at over two periods because you basically take your average through the years. You need your numbers which would occur in one financial year and then you call the figures for the current financial year that you use to incur on your computer data.
So, if we look at, say in 2008, we're going to say that a company has assets of 1.5 million and liabilities of 700,000 which give a shareholder's equity of 800,000. By the end of financial year '09, we're going to say that the assets increased to 1.
750 and the liabilities also increased to 980,000, so shareholder's equity, that actually comes down to 770,000 pounds. We're going to save from the income statement and pick out the net profit of the company, so we're going to say in this example, it's 220,000 pounds. So, return on equity is simply your net profit, 220, divided by your two figures for your shareholder's equity, which gives a return of equity of 28% which as it is above, your 25% would say that it's really a good performance and stretching to an exceptional performance.
Take now a second example. So we're now going to say our company, we've got assets of 5 million in one year, very few liabilities, 120,000 pounds of liabilities and at the closing point of the recent year, we've got our current assets of 6 million and then we've got liabilities of 1.250.
We got a shareholder's equity in one year 4.88 million and the following year with a big increase in liabilities, it's fairly consistent at 4.750.
We're going to get the net profit, the same as in the previous calculation, 220,000 pounds. So we see that the return on equity there, it we take the average shareholder equity and use that, so we divide 220 by the average, it gives the return on equity of 5%. So, a complete different ROE wherein in example 1, even with the same net profits, the company's not using the funds that it's got from it's shareholders in anyway as well as in example 1, as this 5% deems to be bad.
We just need to be careful that we don't be deceived by a high return on equity because that can happen and we've got companies who have excessive debt levels enough so therefore, they have really high elaborations on that for risky competence, so they just need to be taken into consideration and calculation. .