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
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%|
ROE = (Net profit after tax – Preference dividend) x 100 / Equity share capital paid up
|Less tax 50%||200,000|
|Profit after tax||200,000|
|Less preference dividend 12% (250,000)||30,000|
ROE = 170,000 (Net profit after tax – Preference dividend) x 100 / 800,000
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.
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
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.
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
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.