Profitability - Return on Equity Ratio

What it measures: Profitability (relative to owner’s investment) 

The percentage return on the owner’s investment of money into the firm; 

Allows an owner to compare investment in the business vs other options;

Information drawn from Income Statement and the Balance Sheet;

Represented as a percentage.

The equation:

Net Profit / Total Equity x 100

What the result means:

The return on investment for the owner of a firm. Higher numbers are better for the owners; it means that the net profit obtained from the business each year is high compared to the amount of money invested at the start of the business.

Higher results indicate a successful business; the Return on Equity ratio is directly influenced by the Debt to Equity ratio (capital structure) of a firm. Highly leveraged firms (high debt, low equity) can boost Return on Equity but increases overall long-term risk (solvency). Risk is relative to reward. Low results indicate owners may be able to obtain a better return by withdrawing funds from the firm and investing elsewhere for better returns.

Sample Statement:

Net Profit ($45,000) / Total Equity ($125,000) x 100 = 36%

The owners of this firm received 36% of their initial investment in profit from this period of operation. This is a great comparative result, indicating strong business performance or high levels of gearing / leverage / debt.

The business' profitability and the owner's return on their investment in the business is improving over time. Profits from the previous year are being reinvested into the business (see the Owner's Equity go up by the Net Profit amount from the previous year?). The return of 27.9% for the owner in 2024 is quite strong - better than most other alternative investment vehicles. 

But what if the business used more debt? What if the owners changed the capital structure of the business - by replacing owner's equity with debt? That is, if they increase the gearing or leverage in the business' capital structure? This will lift the Debt to Equity ratio and reduce solvency, but what might it do to the owner's Return on Equity?

See how the Owner's Equity decreased by $300,000 and the Total Liabilities increased by $300,000. They secured a loan and reclaimed (withdrew) some of their Owner's Equity ($300,000) to perhaps invest elsewhere. NOW - NOTHING has changed in the running of the business. ONLY the capital structure has changed; how the business' assets were funded. The net profit remains the same, but because the owner has less of their money invested in the business, proportionally, the return on their investment increases dramatically - it basically doubled. THIS is how debt can enhance financial returns to owners - so long as the Debt to Equity ratio doesn't blow out too far to risk insolvency in the face of adverse conditions...

How to Improve the Return on Equity ratio:

• Lift prices

• Sell less for the same price (shrinkflation)

• Change supplier or negotiate better deal with supplier for bulk purchases (economies of scale - but then need to consider Inventory Management)

• Reducing expenses / improving efficiency.

  • Reduce cost of operations (outsourcing, better technology, lower energy use, less waste and defects, reduce transport / logistics)

  • Reduce cost of marketing OR improve ROI on marketing spend (more sales from less promotional spend)

  • Reduce cost of human resources (contracting, downsizing, reduce staff turnover - less recruitment and training expenses)  

• Utilise debt to enhance returns (everything else is exactly the same as the Net Profit ratio)

Return on Equity ratio is Negatively Impacted by:

• Competition or price wars (forcing prices down squeezes margins)

• Sales Promotion or Price Penetration strategy (lowering prices to gain sales and market share)

• Suppliers lifting their prices (higher COGS)

• Customer buying power (if a big and powerful customer like Woolworths negotiates a lower price to access their shelves)

• Product Life Cycle in decline (price reduction) 

• Increasing expenses / decreasing efficiency.

  • Increase in expenses - cost of operations (energy, higher defect rate, more waste, technology breakdowns, accounting / legal expenses)

  • Increase in expenses - marketing spend (new promotional advertising campaign) 

  • Increase in expenses - Human Resources (labour, rewards programs, training expenses, recruitment expenses)

• Lift in interest rates (if business uses debt to increase returns)