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Hello Investors

Wishing all the readers a very happy new year!!!

Nowadays ROE & ROTC are very commonly employed in taking investment decisions; this article is meant to provide an insight of these financial ratios, how to use them and their drawbacks.

Return on Equity (ROE) or Return on Shareholder’s Equity or Return on Net worth:


Return on Equity refers to the net income generated by an entity as a percentage of shareholder’s equity. In simpler terms,

ROE = Net Income/Shareholder’s Equity
Where,
Net Income = Fiscal year net income (before equity dividends )
Shareholder’s Equity = Total Assets – Total Liabilities ; or  Share capital+ Reserve & Surplus

It is used by the investors to ascertain how much profit a company is able to generate with the moneys shareholders have invested. Also, it depicts management’s ability to generate income as compared to the peer companies.
Generally a consistent rate of above 15 % is considered decent. However, it may change a slight on the basis of the sector to which a company belongs.

Let us understand further through an example of Company A
Liabilities (in Rs.)
Assets (in Rs.)
Shareholder’s  Funds :
Fixed Assets                                     2,00,000
Share Capital                                        25,000

 Reserves & Surplus                             25,000

Bank Loan                                         1,50,000

               
Here, Shareholder’s Equity = 25000+25000 = Rs. 50,000 and let Net Profit = Rs. 5000
Hence ROE = 5000/50000 = 10%... i...e... a company is able to generate a return of 10 % on invested capital (hence, the same being below the standard of 15% is not attractive).


CAUTION

The problem with looking at high rates of return on shareholders' equity is that some businesses purposely shrunk their equity base with large dividend payments or share repurchase programs. They do this because increasing the return on shareholders' equity makes the company's stock more enticing to investors. Moreover, as in the example  it cannot be said that the profits have been originated from the shareholder’s equity alone, as the company have also used significant debt.

Let’s take the same example of Company A again and let us now assume company paid out dividend of Rs. 25000 from its reserves and meanwhile raised a debt to meet its operations to the tune of Rs. 25000 as under:

Liabilities (in Rs.)
Assets (in Rs.)
Shareholder’s  Funds :
Fixed Assets                                                  2,00,000
           Share Capital                                        25,000

           (Reserves & Surplus)-(Dividend)        NIL            

Bank Loan(150000+ New loan Rs 25000)   1,75,000                                                  


Here ROE becomes = 5000/25000 = 20%, which turns attractive. However, there is no such change on operational front. Therefore, the same is misleading.

LEARNING POINT

Investors should look for the companies which have high ROE’s along with a very little or no debt portion.

Return on Total Capital : (Solution to the drawbacks of ROE)


In order to assess the capability of management in case companies have significant debt portion or is showing inflated ROE as above, ROTC is the best measure. It is calculated as under:

ROTC = Net Profits/Total Capital Employed
Where,
Total capital employed = short term debt + long term debt + shareholder’s equity

A ratio of about 12 % here is considered decent. Therefore, In above example:

Liabilities (in Rs.)
Assets (in Rs.)
Shareholder’s  Funds :
Fixed Assets                                                  2,00,000
Share Capital                                        25,000

(Reserves & Surplus)-(Dividend)            NIL    

Loan(150000+ New loan Rs 25000)      175000


ROTC = 5000/200000 = 2.5% which is again not attractive. Hence, the same is to be used to evaluate the companies with significant debt portion in its books.

Note: Investors should note that the above standard rates of 15% and 12%  are not applicable to the Banking and Financial Companies as they accept deposits with a lower rate and offer loans at slightly higher rate, leading to grater quantum of debt portion in balance sheet but the returns comparatively stay on lower side.

For example, Suppose a bank pays interest of 7.5% on fixed deposits of Rs. 10000 and allots the said amount to a home loan at 8.5%. This results in lower than 12% or 15% return but a debt of Rs. 10000 stands tall in books. Therefore, the above rates are not to be applied.
Instead one can use return on total assets ..i.e… Net profit/ Total Assets ( Signifying the return the bank is able to generate on its assets). A rate of 1.5 % here is considered good.

Hence, the Investors should keep these stuff in mind and should not be carried away by inflated ROEs

Thanks !!!



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