Financial modelling terms explained

Return On Equity

The return on equity (ROE) ratio is a financial ratio that compares a company's profits to its shareholders equity. ROE can be calculated by dividing the net income after tax by the shareholders' equity.

What is Return On Equity?

Return on equity (ROE) is a measure of a company’s profitability that takes into account the amount of money shareholders have invested in the company. It is calculated by dividing a company’s net income by its shareholders’ equity. ROE can be used to compare the profitability of companies in different industries or to compare a company’s profitability over time.

How Do You Calculate Return on Equity?

Return on equity (ROE) is a measure of a company's profitability that takes into account the amount of equity capital it has employed. The formula for ROE is:

ROE = Net Income / Equity Capital

This equation can be rearranged to find Equity Capital:

Equity Capital = Net Income / ROE

The higher the ROE, the more profitable the company is relative to the amount of equity it has invested.

There are a few ways to improve a company's ROE. One is to increase net income, either through higher sales or by reducing costs. Another is to increase the equity capital the company has invested, for example by issuing more shares or retaining more earnings. A third way to improve ROE is to use debt financing instead of equity financing. This increases the company's debt-to-equity ratio, but it also increases the return on debt (ROD), which is a measure of how profitable the company's debt investments are.

ROE is an important metric for investors because it shows how effectively a company is using its equity capital to generate profits.

Who Uses Return On Equity?

Return on equity is one of the most important metrics used by investors and analysts in the valuation of a company. A high return on equity indicates that a company is generating a high level of profits from its shareholders' investment and is using its resources efficiently. This makes the company a more attractive investment and is likely to lead to a higher stock price.

A company's return on equity can also be used to measure its performance relative to its peers. A higher return on equity than its competitors indicates that the company is doing a better job of generating profits from its shareholders' investment. This can give the company an edge in the competitive marketplace.

Return on equity is also a key metric used by banks in the assessment of a company's creditworthiness. A high return on equity indicates that the company is in a strong financial position and is likely to be able to repay its debts. This makes the company a more attractive borrower and can lead to a lower interest rate on its debt.

What Do You Have to Watch out for When You're Performing Return on Equity?

There are a few things to watch out for when performing return on equity calculations. One is that you must use the same accounting standards for all companies in the calculation. Another is that you must use the same time period for all companies. You must also use the same capital structure for all companies, and make sure that you take into account all expenses and income. Finally, you must make sure that you are comparing similar businesses, so you should compare companies in the same industry.

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