Return on Equity Capital: Explanation

Equity shareholders are the real owners of a company. They bear all the risk, whereas preference shareholders have priority of payments of dividends and as well as capital.

The rate of dividend on equity shares differs from year to year depending upon the amount of profit. A company’s performance is judged based on the amount of return on equity capital.

Formula For Return on Equity Capital

To calculate return on equity capital, use the following formula:

Return on equity capital = (Net profit after tax – Preference dividend) / Equity share capital

Example

Calculate the return on equity capital using the following information:

10,000 shares of $100 each, $80 paid 800,000
12% 5,000 preference shares of 50 each 250,000
Profit before tax 400,000
Rate of tax 50%

Solution

ROE = (Net profit after tax – Preference dividend) x 100 / Equity share capital paid up

Profit 400,000
Less tax 50%  200,000
Profit after tax 200,000
Less preference dividend 12% (250,000) 30,000
170,000

ROE = 170,000 (Net profit after tax – Preference dividend) x 100 / 800,000
= 21.25%

Comment: This ratio is useful for equity shareholders who want to know how profitable the company is, thereby determining the size of the dividend they will receive.

Earnings Per Share (EPS)

The shortcut for calculating EPS is to divide profit after tax and the preference dividend by the number of shares.

Example

Continuing with the details from the first example:

EPS = 170,000 (Net profit after tax – Preference dividend) x 100 / Number of equity shares
= 170,000 / 10,000 = $17 per share

Current Assets Movement or Efficiency Activity Ratio

These ratios are also known as turnover ratios because they indicate the speed at which assets are converted into sales. These ratios are calculated on sales.

Inventory turn over ratio = Cost of sales / Average Stock

Opening Stock = (Opening Stock + Closing stock) / 2

Example

Consider the following information:

Opening stock = $20,000

Closing stock = $10,000

Purchases = 50,000

Carriage on purchases = 5,000

Sale = $1,00,000

Required: Calculate the stock turnover ratio (STR), which is equal to the cost of goods sold divided by the average stock.

Solution

Cost of goods sold = Opening stock + Purchase + Carriage – Closing stock
= 2,00,000 + 50,000 + 5,000 – 10,000 = 65,000
Average stock = (Opening stock + closing stock) / 2
= (20,000 + 10,000) / 2
= $15,000

Therefore, the stock turnover ratio is 65,000 / 15,000 = 13:3

Comment: This ratio shows how many times a company’s stock has been purchased in the course of the year.

Frequently Asked Questions

What is return on equity capital?

Return on equity capital is a profitability ratio that measures a company's ability to generate income with the money shareholders have invested. It is calculated by dividing net income by average equity capital. The higher the return, the more efficient the company is at using its shareholders' money to generate profits.

How to calculate the return on equity capital?

The formula for calculating the return on equity capital is given below:Return on equity capital = (Net profit after tax - Preference dividend) x 100 / share capital

How to find out the current assets movement or efficiency activity ratio?

The shortcut for calculating the current assets movement or efficiency activity ratio is to divide cost of goods sold by the average stock. Cost of goods sold = Opening stock + Purchase + Carriage - Closing stockAverage Stock = (Opening stock + Closing stock) / 2

How to calculate Inventory turn over ratio?

Inventory turn over ratio = Cost of sales / Average Stock Opening Stock = (Opening Stock + Closing stock) / 2

What is the use of EPS?

EPS is used to find out the profit earned by a company on each share held by the shareholders.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

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