- Return of Equity (ROE) reveal how much the company is making compared with how much it has invested to make that.
- ROE = Net Inome / Equity
- It is one of the most important indicators of a firm’s profitability and potential growth
- Companies that boast a high ROE with little or no debt are able
- to grow without large capital expenditures
- allowing the owners of the business to withdrawal cash and reinvest it elsewhere
- DuPont equation
- ROE = Net Income/Equity
- = Net Income/Sales * Sales/Total Assets * Total Assets / Equity -
The sales and total asset on the right side of the equation negate each other, seeing as one is in the numerator and one is in the denominator - = Net Income Margin * Asset Turn Over * Financial Leverage
- It tells where a company's strength lies and where there is room for improvement
- A firm can achieve higher ROE if
- Higher Net Income Margin & asset turn over
- Increase Financial Leverage - when times are good, leverage amplifies ROE, but in bad times, it can hurt ROE badly. And, too much leverage can make a company becoming risky in time of economic downturn and financial crisis.
- It is important to look at the long-term trend in ROE to make sure that it is not steadily declining significantly.
- One must be aware about the economic cycles and that when a company grows bigger, it is harder to continue improving its ROE which is already high.
References:-
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