Return on Equity (RoE) is an essential metric that allows investors to understand the return they can receive per each unit of capital invested. It gives an insight into the company’s ability to convert investments into profits. RoE, as a comparison tool, is especially helpful when it comes to analysing potential investments.
Generally, higher values indicate favourable conditions for shareholders and should be considered when making investment decisions. The expected return on equity rate of large Indian companies ranges from 14-16%. I tend to focus my attention primarily on businesses that reach 18% or more.
This ratio is compared with others in the same industry and tracked over time.
Take note that if the RoE is high, the company generates a good amount of cash, reducing the requirement for external funds. A higher ROE thus illustrates a greater level of management effectiveness.
Net Profit / Shareholders Equity* 100 = RoE
It is clear that RoE is a significant figure to work out, yet like any other financial ratio, it also has some shortcomings. To better comprehend its drawbacks, take this hypothetical example into consideration.
Rajesh operated a bakery and invested Rs.15,000 from his personal savings to purchase a mixer. This mixer is a valuable asset to his business, increasing equity on the balance sheet by Rs.15,000 and also enhancing his total assets by the same amount.
To calculate Rajesh’s Return on Equity (RoE), we need to consider that he earned Rs.3,500 in his first year of business.
RoE = (3500/15000) * 100
Now, let’s consider a different scenario: Rajesh initially had Rs.12,000, but with the financial support of his brother, he managed to acquire a mixer worth Rs.15,000. How does his balance sheet look in this situation?
On the liability side, he would have:
Shareholder Equity = Rs.12,000
Debt = Rs.3,000
Rajesh’s total debt amounts to Rs.15,000, which matches the value of his assets. Let’s analyse his Return on Equity (RoE) in this case.
RoE = (3500/12000) * 100
Next, let’s consider Rajesh having only Rs.8,000 but securing an additional loan of Rs.7,000 from his friend. This has a significant impact on his balance sheet and subsequently affects his return on equity (RoE).
On the liability side, he would have:
Shareholder Equity = Rs.8,000
Debt = Rs.7,000
Rajesh’s total debt now stands at Rs.15,000, while his assets remain unchanged. Taking all aspects of his financial situation into account, let’s calculate his return on equity.
RoE = (3500/8000) * 100
A high return on equity (RoE) can be very beneficial; however, it does come with an increased risk of debt finance. Excessively high debt can cause the finance cost to skyrocket, so it is necessary to inspect RoE closely.
The DuPont Model, also known as the DuPont Identity, can be used as a tool when looking at RoE. With it being essential to weigh benefits against risk before taking on debt, this model is a helpful way to do so.
The DuPont Model, devised by the DuPont Corporation in the 1920s, dissects RoE into three facets. It necessitates a mixture of both the Profit & Loss Statement and Balance sheet for computation.
By consulting the formula, it is noticeable that the denominator and numerator both eliminate each other, so we are left with the RoE equation:
Net Profit / Shareholder Equity *100= RoE
By analysing the RoE formula, we gained an understanding of three different aspects of the business. We will now explore the three components of the DuPont model forming the RoE formula.
The DuPont breakdown of the RoE formula divides it into three different parts, providing information on a company’s performance and financial strength.
Now, let’s utilise the DuPont Model to determine the Return on Equity (RoE) of ARBL for the fiscal year 2014. In order to accomplish this, we must calculate each of the individual components involved.
Earlier, we discussed the Net Profit Margin (the same as the PAT margin), for ARBL; which was calculated to be 9.2%.