2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16
Profitability is a rather broad concept that can be applied to different components of any company. She can choose such synonyms as efficiency, payback or profitability. It can be applied to assets, capital, production, sales, etc. When calculating any of the performance indicators, the same questions are answered: "are resources used correctly" and "is there a benefit?" The same is true for the return on equity (the formula used to calculate it is presented below).
Equity and investors
Equity refers to the financial resources of the owner of the company, shareholders and investors. The last group is represented by people or companies that invest in business development in third-party firms. It is important for them to know that their investments are profitable. Further cooperation and development of the company in the market depends on this.
Financial injections are important for every company - both internal andexternal. And the situation is much more favorable when these funds are represented not by bank loans, but by investments from sponsors or owners.
How to understand whether it is worth continuing to invest in a particular company? Very simple. You just need to calculate the return on equity ratio. The formula is easy to use and transparent. It can be used for any organization based on balance sheet data.
Calculation of the indicator
What does the formula look like? Return on equity is calculated by the following calculation:
Рsk=PE/SK, where:
- Rsk - return on equity.
- IC - equity of the firm.
- PE - net profit of the enterprise.
Recoupment of own funds is calculated most often for the year. And all the necessary values are taken for the same period. The result obtained gives a complete picture of the activities of the enterprise and the profitability of equity capital.
Do not forget that any company can be invested not only with its own funds, but also with borrowed funds. In this case, the return on equity, the calculation formula of which is given above, gives an objective assessment of the profit from each unit of funds invested by investors.
If necessary, the profitability formula can be changed to obtain a percentage result. In this case, it is enough to multiply the resulting quotient by 100.
If you need to calculate the indicator for a different period (for example, less than a year), then you need a different formula. Return on equity in such cases is calculated as follows:
Рsk=PE(365 / Period in days) / ((SKnp + SKkp) / 2), where
SKnp and SKkp - equity at the beginning and end of the period, respectively.
Everything is known in comparison
In order for investors or owners to fully appreciate the profitability of their investments, it is necessary to compare it with a similar indicator that could be obtained by financing another company. If the efficiency of the proposed investment is higher than the real one, then it may be worth switching to other companies that need investment.
The formula developed to calculate the standard value can also be used. Return on equity in this case is calculated using the average rate on bank deposits for the period (Av) and income tax (ATT):
Crnk=Sd(1-Snp).
When comparing the two indicators, it will immediately become clear how well the company is doing. But for the full picture, it is necessary to conduct an analysis of the effectiveness of equity over several years, so that one can more accurately determine the temporary or permanent decline in profitability.
It is also necessary to take into account the degree of development of the company. If some innovations were introduced at the end of the period (for example, the replacement of equipment with more modern ones), then it is quite natural that there will be some decrease in profits. But in this case, the profitabilitywill definitely return to its previous level - and possibly become higher - in the shortest possible time.
About regulations
Each indicator has its own norm, including the efficiency of equity capital. If we focus on developed countries (for example, such as England and the USA), then the profitability should be in the range of 10–12%. For developing countries whose economies are prone to inflation, this percentage should be much higher.
You need to know that it is not always necessary to rely on the return on equity, the formula for calculating which is presented at the beginning. The value may turn out to be too high, as the indicator is influenced by other financial levers. One of them is the amount of borrowed capital. For such cases, there is the Dupont equation. It allows you to more accurately calculate profitability and the impact of certain factors on it.
In the end
Each owner and investor should know the considered formula. Return on equity is a good assistant in any line of business. It is the calculations that will tell you when and where to invest your funds, as well as the right moment for their withdrawal. This is very important information in the investment world.
For owners and managers, this indicator gives a clear picture of the direction of activity. The results obtained can suggest how exactly to continue doing business: along the same pathor change it drastically. And the adoption of such decisions will ensure an increase in profits and greater stability in the market.
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