Return on common equity definition
/What is the Return on Common Equity?
The return on common equity ratio (ROCE) reveals the amount of net profits that could potentially be payable to common stockholders. The measurement is used by stockholders to evaluate the amount of dividends that they could potentially receive from a business. The return on common equity calculation can also be used as a simple measure of how well management is generating a return, given the current amount of equity on hand.
How to Calculate the Return on Common Equity
To calculate the return on common equity, subtract dividends on preferred stock from net profits, and also subtract preferred stock from equity. Then divide the the net profit less preferred stock dividends figure by the equity less preferred stock figure. The return on common equity formula is as follows:
(Net profits - Dividends on preferred stock) ÷ (Equity - Preferred stock) = Return on common equity
This calculation is designed to strip away the effects of preferred stock from both the numerator and denominator, leaving only the residual effects of net income and common equity. If a business has no preferred stock, then its calculations for the return on common equity and the return on equity are identical.
Related AccountingTools Courses
Disadvantages of the Return on Common Equity
The ROCE metric is not a good one, for the reasons noted below.
Profits Do Not Match Cash
The amount of profit reported does not necessarily coincide with the amount of cash on hand that would be used to pay dividends. Thus, a company reporting a large profit may have no cash with which to pay dividends. This situation is especially common when a business uses the accrual basis of accounting, since the accrual basis may require journal entries to accrue revenue or expenses for which there is not yet a related cash receipt or payment, respectively.
Dividends Do Not Match Profits
There is not necessarily any relationship between the amount of dividends paid and the profits generated in any given period. Instead, the board of directors (which authorizes dividends) likes to achieve consistency in the amount of dividends paid from period to period, which means that dividend payments tend to be more stable than profits (which may fluctuate substantially).
Size of Debt Obligations
If a business has a large amount of debt payments, there may be few funds available for the payment of dividends to the holders of common stock.
Bankruptcy Risk
Management could be funding operations with debt, rather than equity. Doing so increases the return on common equity, but risks bankruptcy if management cannot pay off the debts in a timely manner. Thus, a business could be reporting a sterling return on common equity figure, and yet be at risk of complete failure due to an excessive debt load.
When to Use the Return on Common Equity
A better use of the measurement is to couple it with an analysis of where a company is in its life cycle. A mature business with a high ROCE is more likely to have enough cash on hand to pay dividends. Conversely, a rapidly-growing business with a high ROCE may have so little cash that it cannot possibly pay any dividends.