Return on equity definition
/What is the Return on Equity?
The return on equity ratio reveals the amount of return earned on the shareholders' equity invested in a business. The measurement is commonly used by investors to evaluate current and prospective business investments.
Calculation of the Return on Equity
To calculate the return on equity, simply divide net income by the total amount of equity. The formula is:
Net income ÷ Equity = Return on equity
The numerator can be modified to only include income from operations, which yields a better picture of the value generated by the operational capabilities of a business, with all financing issues stripped out.
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How to Improve the Return on Equity
The return on equity can be improved when a business buys back its own stock from investors; doing so reduces the amount in the denominator of the equation, thereby increasing the reporting return. Another improvement option is to use more debt and less equity in a firm’s capital structure. Doing so also reduces the equity total in the denominator, which increases the reported return. Both options have associated risks. If you use excess cash to buy back stock, then this reduces a firm’s cash reserves that might have been available in the event of a financial crisis. And, if you add more debt to the balance sheet, an economic downturn might reduce your cash flows, making it difficult to pay back the debt.
Problems with the Return on Equity
The use of debt to buy back stock and thereby increase the return on equity can backfire. The new debt brings with it a new fixed expense in the form of interest payments. If sales decline, this added cost of debt could trigger a steep decline in profits that could end in bankruptcy. Thus, a business that relies too much on debt to enhance its shareholder returns may find itself in significant financial trouble. This is a particular concern in highly competitive industries where market share can fluctuate, since one’s cash flows will not be steady enough to make loan payments with any regularity.
Example of the Return on Equity
The president of Finchley Fireworks has been granted a bonus plan that is triggered by an increase in the return on equity. Finchley has $2,000,000 of equity, of which the president plans to buy back $600,000 with the proceeds of a loan that has a 6% after-tax interest rate. The following table models this plan:
| Before Stock Buyback | After Stock Buyback | |
| Sales | $10,000,000 | $10,000,000 |
| Expenses | 9,700,000 | 9,700,000 |
| Debt interest expense | --- | 36,000 |
| Profits | 300,000 | 264,000 |
| Equity | 2,000,000 | 1,400,000 |
| Return on equity | 15% | 19% |
The model indicates that this strategy will work. Expenses will be increased by the new amount of interest expense, but the offset is a steep decline in equity, which increases the return on equity. An additional issue to be investigated is whether the company's cash flows are stable enough to support this extra level of debt.
The type of financial engineering described in the example to improve the return on equity should be periodically re-examined, to account for any changes in the underlying fundamentals of the business.