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.
Explain Return on Equity Capital With Examples FAQs
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.
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
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
Inventory turn over ratio = Cost of sales / Average Stock Opening Stock = (Opening Stock + Closing stock) / 2
EPS is used to find out the profit earned by a company on each share held by the shareholders.
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
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.
To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.
