Today we are going to review what Return on Equity is and why is it important for shareholders. One of the main objectives of any company is to generate profits for its shareholders. And obtaining the highest return on their investment is the goal of all those who invest their capital in a business, no matter if it is a large or small company. That is why having the necessary tools to evaluate the profit and net return on capital is essential. Today we are going to present one of the most important financial indicators to know the profitability of a company: ROE.
The most widely used and reliable financial indicator to determine the value of the return on investment capital is currently the ROE (Return on Equity). This indicator provides a quick and precise indication of the real situation of the company’s return on equity.
What is ROE (Return on Equity)?
ROE (Return on Equity) is a very reliable financial tool that has been used for some time now by banks and, in general, by all companies. Its purpose is to show whether the invested capital is giving the desired return. In other words, the results obtained by its application will indicate whether the company is making profits or losses and to what extent. This information is fundamental to determine the success or failure of the business.
It basically consists of measuring the profitability obtained on the company’s own resources, expressed in mathematical form. In other words, the calculation of net income based on the capital invested by its shareholders expressed in numerical form. Thus, shareholders and associates will have clear and precise information on the economic behavior of the company and the results obtained in a period or fiscal year. And these results are expressed as positive or negative percentages.
The current and future capital of the company may depend on the results obtained by this efficiency ratio. If the result obtained is too low or even negative, it means that the economic management of the company in general is bad or negative. And possibly its possibilities of growth are very low or null. Neither will it be able to provide its shareholders or associates with the expected profit. This may cause them to decide to withdraw their investment capital.
How is ROE calculated?
Despite its great importance as an indicator of efficiency for companies, the calculation of ROE is extremely simple. It only requires the intervention of two variable values. The value of net profit, after deducting expenses and taxes, and the amount of equity investment. Knowing that the latter are the result of subtracting the company’s liabilities from its assets. Expressed numerically in the following mathematical formula.
ROE = Net Profit / Shareholders’ Equity.
This simple mathematical formula is responsible for showing the profitability obtained by the company during its fiscal year or a determined period of time. The reliability of the results of this calculation is directly linked to the veracity of the information provided by the people in charge.
For this reason, the accuracy of the data provided is of vital importance for the company and its shareholders. Wrong or erroneous information will yield different results that do not correspond to the true situation of performance and efficiency of the company being analyzed. This may lead to wrong decision-making based on the results obtained. This will result in the possible decapitalization of the company. If the performance presented is below the desired performance, shareholders will most likely withdraw.
Why ROE is important for shareholders?
The main objective of any investment is to obtain the highest possible return on the capital invested in a business. Nobody wants to invest in order to lose their money. And, in order to prevent this type of situation, financial indicators are there. These parameters have the sole function of analyzing and informing investors and shareholders of the return obtained by the company based on the capital contributed.
Having an indicator of the company’s efficiency is very important for anyone who invests or plans to invest their capital in it. ROE is considered one of the most important efficiency and profitability indicator ratios used by companies in all different economic sectors. It is a very useful indicator to follow the evolution of the company. In addition, it also helps to see the capacity to generate profits on the capital deposited by shareholders, investors and associates in it.
The importance of ROE as a financial indicator ratio lies in the fact that it shows the financial profitability of the invested capital. This, in turn, allows investors to make a judgment on the management’s performance by knowing how the capital provided is being used. Consequently, the ROE tries to measure the company’s capacity to multiply the invested capital and provide a higher return to its shareholders on the basis of its contributed capital.