ROE is one of the most widely used financial tools for Evaluate the profitability of a company. This is a key indicator for shareholders and investors, since, in short, it measures the financial profitability that the company generates for its shareholders.
In this article we show you the meaning and interpretation of ROE, how it is calculated and what its usefulness is. Finally, we also contrast it with the ROA, another of the most relevant ratios.
What is ROE?
ROE is the acronym for Return on Equity, which translates into Spanish as return on equity or return on equity.
Is about a ratio that measures the performance of the shareholders or owners of the company. In other words, the ability of assets to generate profitability. It's a indicator of the financial health of a company.
A company uses its own and external sources of financing. The own sources come from their heritage. ROE indicates the profitability that the company obtains by investing its capital and reserves.
How is ROE calculated?
ROE is a ratio. That is, a relationship between two magnitudes; in this case, the net profit obtained divided by the own funds used to achieve it. The formula is the following:
ROE = Net profit (after taxes) / Equity
We recall that the company's own funds are the result of deducting the liabilities required from the total assets that the company has. In short, it is the net worth of the company.
What is the utility of ROE?
If a company has a high SWR, means that you use your equity efficiently and it pays off for shareholders to keep their money invested in the company.
What's more, it is even possible that the company allocates its profits to increase its reserves to finance other projects. If the company itself earns a high return on those funds, this no-dividend policy may even benefit shareholders, since they earn better returns than they could if they invested them on their own.
Of course, the value of this ratio must be positive and higher than shareholder expectations. If the ROE were negative or lower than expected, is a symptom that management is deficient and the company's capital is not being used correctly. Growth prospects suffer.
ROE tracking is useful for measure the evolution of the company and compare the behavior of its profitability with other companies in the sector, with the past of the company itself and with the industry average.
It may also be interesting to compare its value with the return on investments considered risk-free (for example, public debt) to observe the difference. In addition, it can be used to establish objectives and forecasts.
What is the difference between ROE and ROA?
He ROA (Return of Assets) is another of the most used ratios for measure company management. It differs from ROE in that it relates the profit obtained between the total assets of the company and not the net worth.
In other words, the ROA measures the profitability that the company obtains from all the financing, whether its own or from others. Meanwhile, ROE only takes into account own financing: it refers to the benefits it generates for shareholders (since they are the ones that provide the company's own financing, that is, the capital).
The formula for calculating ROA is as follows:
ROA = Net profit (after tax) / total assets
Both indicators can help you measure the financial and economic profitability of a company. It's not about facing ROA vs ROE, but to complement the interpretation of both to obtain a more global vision of business management.