ROE: What is it and how to improve it?

The Return on Equity (ROE), relates the net profits obtained in a specific investment operation to the resources required to achieve it.

As a financial index, ROE shows how efficiently a company is being managed, as the return on equity is a measure of the income a company can generate from the capital owned by shareholders.

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The higher the return on equity, the more valuable the company appears to investors. A company can improve its return on equity in several ways. In this article, we'll tell you all about ROE, how to calculate it, and add some best practices for improving it.

What Is The Return on Equity?

The return on equity ratio measures the rate of return that common shareholders of a company receive on their holdings. It is important because it shows how effectively the company's management is at generating returns from the cash received from its shareholders.

In general, investors prefer companies with higher ROE because it indicates that the company can make better decisions with the cash and assets it possesses.

How Is ROE Calculated?

In mathematical terms, the return on equity is the company's net income (found on the income statement) divided by the shareholders' equity (found on the balance sheet). Multiply by 100 to express the ratio as a percentage.

Return on Equity (ROE):

Net Income / Shareholders' Equity

Let's assume, for example, that ABC Company has generated annual profits of $30,000 and has shareholders' equity of $500,000.

ROE = 30,000 / 500,000

ROE = 0.06 or 6 percent.

Whether this is a good rate of return depends on what is normal for the industry. For instance, the utility industry tends to carry many assets on the balance sheet compared to a relatively small amount of annual profits. A normal ROE in this sector might be 10 percent or less. Less asset-intensive industries may struggle to achieve an ROE double that percentage.

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How Can ROE or The Return on Equity

Be Improved?

Take another look at the return on equity formula and note that it consists of two parts:

• Net Income.
• Shareholders' Equity.

Change either of these figures, and by definition, the ROE will change.

Drilling down into the denominator, the figure for shareholders' equity, as shown on the balance sheet, is calculated by subtracting the company's total liabilities from the total of its assets. Liabilities include loans payable in more than one year, equipment loans, and deferred tax liabilities. Assets include cash in the bank, inventory, and anything else that has economic value for the company.

1. Effect of Financial Leverage on ROE.

Most companies have the option to finance themselves through debt capital (loans) or equity capital (shareholders). The return on equity will increase if equity is partially replaced by debt. The more loans a company has, the lower its shareholders' equity.

2. Handle Leverage with Care.

Leverage is something that should be managed carefully. Increasing debt raises the interest payments on corporate loans, so in reality, a debt-financed company is likely to have a lower after-tax profit than an equity-financed company due to the interest expenses.

Furthermore, if a company has aggressively borrowed, the increase in ROE can be largely artificial, especially if the company uses debt to buy back its own shares. Taking on debt forces ROE to increase significantly, but this does not represent the actual growth rates or performance of the company.

However, financial leverage almost always increases ROE, as long as the cost of debt doesn't get out of control. If interest payments are higher than the return on total assets, a ratio that measures a company's earnings before interest and taxes in relation to its total net assets, this positive leverage effect no longer applies.

3. Improve ROE by Increasing Profit Margins.

The other side of the ROE formula is net income, also known as earnings. Increasing earnings will invariably improve ROE as long as shareholders' equity remains the same.

There are several ways to increase profits, and it's not necessary to sell more products. For example, you could take the following actions:

• Raise product prices.
• Negotiate with suppliers or change packaging to reduce the cost of goods sold.
• Reduce your labor costs.
• Cut operating expenses.
• Any combination of these approaches.

4. Reduce Assets by Managing Idle Cash.

Having more cash on hand than your business needs to operate may seem like a good problem, but idle cash reduces your company's profitability as measured by ROE. Distributing cash to shareholders is a smart way to leverage the company, thereby improving capital performance.

Remember that cash is an asset on the balance sheet and is therefore a component of shareholders' equity (comprised of assets minus liabilities). When cash accumulates, it increases the shareholders' equity figure, which in turn reduces ROE.

5. Increase ROE by Reducing Inventory.

Inventory is an asset, but too much inventory can be a liability. If you tend to have more inventory than you can use right away, it will affect your ROE: firstly, because you have additional storage expenses that reduce your net income, and secondly, because your inventory figure, and thus your shareholders' equity, will be too high.

In the example at the beginning, ABC Company was an inefficient operator with excessively high inventory. Now, it is implementing an improved "just-in-time" inventory control system, purchasing fewer inventory items in advance. As a result, the inventory value drops significantly.

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In conclusion, the return of equity or ROE measures the efficiency of your management in your company, allowing you to understand how high or low the return on cash, earnings, and assets is compared to the available financial capital. Distributing cash to your shareholders to improve capital performance and make your company more profitable is key.