Each company has three types of returns, namely return on assets (ROA), return on investment (ROI), and return on equity (ROE). All three have their respective roles and functions. However, for investors, ROE is the most interesting type of return to know. Among the three types of company returns, the calculation of return on equity is the cleanest, because various expenses have been deducted.
Just like other types of returns, the calculation of ROE can reflect the company’s performance. However, ROE shows more data on net income with a certain capital. You can read more about the meaning of ROE, how to calculate it, and the ROE formula below.
In business and economics, the notion of ROE is a metric to compare the total net income of a company and the total amount of investor / owner capital in it. Meanwhile in the stock world, the notion of ROE is the amount of net business income per incoming investor funds.
ROE or return on equity is one of the important elements to determine the extent to which a business is able to manage the capital of its investors. If the calculation of ROE is greater, the company’s reputation will also increase in the eyes of capital market players. This is because the business has proven to be able to make the best use of capital assistance.
Benefits of Using ROE
After discussing what ROE is, this time we will discuss how big the influence of using ROE, especially for investors. More details about the benefits of ROE are as follows:
- Showing the Company’s Profitability Level
For investors, ROE is the easiest metric to find out how high a company’s potential is to generate profits. With the return on equity, investors can draw conclusions about the profitability of stocks easily and quickly.
- As a Basis for Estimating Future Business Profits
In fact, ROE is one of the most effective benchmarks for predicting future business prospects. If at present the company is proven to be able to generate an ROE of at least 1.0 or more, then in the future there is a possibility that the return on equity will also increase.
- Describing the Company’s Development from Year to Year
The company’s ROE is ideally stable or continues to grow from year to year. By looking at the ROE trend of a business, investors can assess how the profile of the business was in the past and see whether the company continues to grow or is stagnant.
- Become a Comparative Indicator with Competing Companies
Before making investment decisions, investors usually make comparisons between many companies at once. Whoever business has the highest ROE, then he is the one who is most entitled to receive capital disbursement.
- Demonstrating Company Credibility in Managing Assets
ROE is one of the main factors that demonstrates business credibility in managing its capital. The small level of return on equity is one sign that the company is not able to generate profits as expected, even though it has been given an injection of funds by investors.
Factors Affecting ROE
In addition to capital, there are several other factors that affect ROE, including:
- Company Activity Ratio
The first factor that can affect ROE is how big the scale of the company’s activities is. If the business is focusing on branch expansion, for example. It is natural that the ROE is small because expansion requires large funds and new branches will not immediately be able to generate profits.
- Debt Ratio
The next factor that has a big influence on return on equity is the debt to profit ratio. The bigger the company’s debt, usually the ROE value is also getting smaller.
- Liquidity Ratio
In addition to receiving debt, the company also provides receivables to several other parties. If business liquidity is not smooth, then the ROE value will be affected as well. Because even though it has become the property of the business, receivables cannot be categorized as profit.
Return On Equity Formula
Now, you already know what ROE is, its benefits, and the factors that can influence it. This time we will discuss the return on equity formula. This is what it sounds like:
The formula ROE = (Turnover – Cost)/Capital
the formula ROE = Net Income ( Net Income )/Capital
Example of How to Calculate ROE
To make it easier to understand the return on equity formula, this time we will discuss some case examples and how to calculate the ROE.
- ABCD, LLC
In 2020, ABCD, LLC managed to get a total turnover of $ 470 million, while the total expenditure was $ 200 million. In the previous year, ABCD, LLC received funding of $ 100 million, while the remaining initial capital of the founders was $ 150 million. Then how to calculate ROE of ABCD, LLC are:ROE formula
= (Turnover – Cost) / Capital
= (Rp470 million – $ 200 million) / ($ 100 million + $ 150 million)
= $ 270 million/ $ 250 million
= 1.08So, the return on equity of ABCD, LLC is classified as normal with a slight excess of 1.0.
- EFGH, LLC
In mid-2021, EFGH, LLC has a net income of $ 275 million, and has a personal capital of $ 350 million. Then how to calculate ROE of EFGH, LLC are:The formula ROE
= Net Income/Capital
= $ 275 million/ $ 350 million
= 0.78This figure is still relatively healthy, but this indicates EFGH, LLC is still unable to return its investment in the middle of the year.
Advantages of ROE
How, do you understand the return on equity formula and how to calculate it? If so, we will discuss some of the advantages of ROE, including:
- The Formula is Simpler
The first advantage of ROE is its very simple formula. As long as the data is available, investors can calculate the ROE of their investment target company by themselves.
- Describing Real Profits
Because the basis for calculating ROE is net income, company stakeholders can find out how capable the business is in generating profits and maintaining its name.
- Can be used as a benchmark for performance evaluation
ROE is one of the best materials for conducting evaluations, especially those related to management performance. If the company is proven not to be trusted to maintain the ROE figure, investors can hold a GMS to replace the board of directors.
Weaknesses of ROE
While seemingly effective, return on equity is a metric with fundamental flaws here and there, the full details of which are as follows:
- Potentially Reduces Company Motivation
The first weakness of ROE calculation is the decrease in company motivation in conducting business experiments. Because the orientation of the value of profit must be above costs, employees and management will find a safe way without innovating.
- Lack of Consideration of Capital Depreciation
The next drawback of return on equity is the lack of attention to capital depreciation. ROE doesn’t matter how old the real fixed capital like machine / building is when it’s calculated. So even though the company is actually stagnant, its ROE level remains high due to a reduction in nominal assets. This will be very detrimental to investors.
- Sometimes Not Suitable For Newly Founded Companies
The last drawback of ROE is that it is not suitable for start-up companies. Generally, start-ups will not be able to have a high ROE at the beginning, because the product is still in the introduction stage to the market.
That’s the discussion from us about the meaning of ROE, benefits, factors, plus minus, as well as the ROE formula and how to calculate it! ROE is one of the easiest return calculation formulas to use.
However, you should not use the ROI value as the only reference in maintaining company productivity. To be complete, use other indicators such as ROA and ROI and also consider the company’s long-term goals.