6. What is the return on equity (RE) of a firm? Explain the ways to calculate...

6. What is the return on equity (RE) of a firm? Explain the ways to calculate it.

Expert Solution

Return On Equity (ROE) - It examines the profitability from the prespective of the equity investors by relating profits available for the equity shareholders with the book value of the equity investment. As the ROE is based on earnings after interest payments, it is affected by the financing mix the firm uses to fund its projects. It means, the firm that borrows money to finance projects and earns ROA (Return On Asset) on those projects that exceeds the after tax interest rate it pays on its debts, will be able to incraese its ROE by borrowings. It is also known as Trading On Equity. The ROE indicates how well the funds of the owner have been used by the firm. It also examines whether the firm has been able to earn satisfactory return for the owners or not. Therefore, the owners of the firm would be more interested in the ROE analysis.

Ways to calculate:

ROE = ((Profit After Tax- Preference Dividend)/ Equity Shareholders Funds)*100

As per the Du Pont Analysis, ROE can also be explained as:

ROE= (PAT/ sales) * (Sales/ Total Assets)* (Total Assets/ Shareholders Fund)

= Profit margin* Total Assets Turnover*Equity Multiplier

jeff jeffy answered 1 year ago

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