What is Return on Equity (ROE) and How to Calculate It?

Return on equity is a crucial tracker to check the performance of a company’s financials. Return on equity indicates how well a company has been utilizing investor’s money to generate profits. A good return on equity makes the company more attractive to investors and debtors. 

What is the return on equity?

Return on equity gives how well a company utilizes its equity capital to generate net income. ROE is typically calculated by using the following formula:

Return on equity (ROE) = Net income generated / Total shareholder’s equity

Here, Net income generated is the profits generated post-tax or the bottom line. Total shareholder’s equity indicates the non-debt funding sources of the company. 

Example 1

Suppose a company generates 2,000,000 USD in net income in the financial year of 2022. The total shareholder’s equity for the company is 12,000,000 USD for the same period. 

The return on equity for the company comes out to be 2,000,000 / 12,000,000, which is 16.67%. 

Example 2

A company has net earnings of 100,000 USD. The shareholder’s equity is found to be 1,000,000 USD. 

The return on equity hence comes out to be 100,000 / 1,000,000, which is 10%. 

What does return on equity mean?

Return on equity has a significant impact on the creditworthiness of your company. 

Impact of high ROE

A high ROE is generally a good indicator for the company’s shareholders. A high ROE indicates that the company is generating a pleasing net income and can result in shareholder confidence or in attracting more investors. 

Impact of low ROE

A low return on equity indicates that the company is creating a relatively low net income and is burning most of the shareholder’s equity. This makes the company less attractive to investors and shareholders. 

Importance of maintaining a stable ROE

A gradual increase in ROE over time is a good signal of a company improving its financial health. A company whose ROE constantly goes up and down might be lower in creditworthiness than a company with gradually increasing ROE. 

The DuPont formula

Though the return on equity is an important metric to check a company’s financial performance, a lot of other factors also play a significant role. Looking at all the factors impacting a company’s creditworthiness, the DuPont formula breaks down return on equity into three crucial factors influencing financial performance. 

Profit margin

The profit margin indicates how a company’s revenue exceeds its cost to generate money. It shows how good the company is at making money. The profit margin in the DuPont formula is calculated as follows:

Profit margin = Net income / Revenue

Asset turnover

Asset turnover is an indicator of how well a company utilizes its assets to generate revenue. Asset turnover is calculated in the DuPont formula as follows:

Asset turnover = Revenue / Average total assets

Here, average total assets are calculated as follows:

(Assets at the beginning of the period + Assets at the end of the period) / 2

Financial leverage

Financial leverage is an indicator of how well a company manages its debts. Financial leverage in the DuPont formula is calculated by: 

Financial leverage = Total assets / Average shareholder’s equity 

The DuPont formula then calculates the return on equity by considering all three factors: profit margin, asset turnover and financial leverage. 

Therefore, ROE = Profit margin x Asset turnover x Financial leverage

Essential metrics for financial health

Multiple metrics are essential for your company’s investors. Here are three primary metrics that can be used to judge a company’s creditworthiness: 

Return on equity

Return on equity indicates how well a company has utilized funds from its shareholders. It is used as an indicator of shareholder happiness. A company generating a high return on equity will be able to pay dividends to their shareholders more than one that doesn’t.

Return on assets

Return on assets is a measure of how efficiently a company generates revenue by utilizing its assets. A higher ROA indicates that the company can generate more revenue with a smaller shareholder investment. 

Return on invested capital

Return on investment capital measures how well a company makes profits regarding its capital. In ROIC, both debt and equity capital are considered. It is an essential indicator for debtors and shareholders alike. 

How to maintain a good ROE

Maintaining a good return on equity is vital for funding your business. Here are a few tips to utilize your equity capital better:

Cost-optimization

Cost optimization is one of the best ways to increase net income and, consequently, return on equity. Conducting regular audits and constantly finding areas of improvement and cost-cutting can help financial leaders manage their cash flow better and reduce losses due to maverick spending and fraud. 

Supply chain optimization

Optimizing your supply chain can also help you generate higher revenues with lower costs. This increases net income. Adopting technological solutions to manage supply chains can help create more profit and better plan your company’s growth. 

Risk management

Managing risks in business, such as fraud or supply chain risks, can also reduce the likelihood of a fluctuation in ROE. Having a plan for working capital and maintaining profitability can help your company maintain a good return on equity without disrupting business operations. 

Share buybacks

Share buybacks also reduce the number of shares in the company, lowering shareholder’s equity. This, in turn, will improve the ROE of the company. 

Improving pricing strategies

Improving the pricing strategies of your business to increase net revenue can also increase your return on equity. Conducting thorough market research and customer segmentation can help in this area. 

How AP automation can help improve return on equity

Labor efficiency

AP automation can help reduce the manual workload on your accountants’ shoulders with the help of invoice automation. This automates tasks like data entry, invoice matching, GL and cost center assignment and approval routing, which takes up most of your accountants’ bandwidth. This allows them to focus on more strategic workstreams instead. 

Cost control

AP automation also reduces the number of manual errors made in the AP process and prevents duplicate payouts. Some AP automation vendors, like ClearTech, give important savings insights like spikes in line items and other essential vendor insights.

Timely payments

With smart payment run creation, you can pay your vendors promptly, avoiding late payment fees and capturing early payment discounts.

Real-time visibility

ClearTech also gives you real-time visibility into your company’s spending and AP patterns, allowing you to manage your working capital better. A savings dashboard also provides essential insights, such as unused licenses and better vendor alternatives to reduce dead costs. 

Conclusion

Return on equity is a measure of how well a company uses its shareholder’s equity to generate profits. It is an essential metric for shareholders and investors to gauge the creditworthiness of the company. Return on equity is calculated by dividing the net income by the average shareholder’s equity. The DuPont formula calculates returns on equity by multiplying essential factors such as profit margin, asset turnover and financial leverage necessary to investors. A high ROE indicates that the company is managing its shareholder’s equity well to generate profits, whereas a low ROE indicates improper usage of the same. Return on assets and return on invested capital are also essential components when calculating creditworthiness. To improve return on equity, companies must optimize costs, manage their supply chain and risks better, improve product pricing or buy back shares. AP automation software like ClearTech can help improve ROE by optimizing costs and freeing up the finance team’s bandwidth.