POFM - return on equity ratio

Question 1

what is return on equity

Answer 1

measures the net profit before tax and compares it to the equity in the business
measure of the owners reward for the risks involved in keeping the business operating
also measures how much the owners (shareholders) investment is producing profits, and hence the return on their investment

Question 2

If return on equity rises due to increased leverage

Answer 2

the improved result should be seen as carrying increased risk.

Question 3

calculating the return on equity

return on equity ratio=

Answer 3

ROE tells us for every $1 invested by the shareholders how much profit is produced eg: if we have a ROE of 22% then it means each $1 is invested has produced 22c profit
net profit/total equity x 100

Question 4

how to determine/make a judgment on the ratios

Answer 4

o The higher the ratio or % the better the return for the owner.
o In this example 10% would be a reasonable return depending on the type of business, what other businesses are achieving and industry expectations. The owner would also need to consider returns on other types of investments eg: bank interest rates

Question 5

what does this mean

Answer 5

The return on equity ratio measures the relationship between the amount of equity invested and the return on this equity in terms of net profit

It allows us to make a judgement about how effective the funds contributed by the owners have been. Obviously they are looking for the largest percentage possible.

The return on equity percentage has to be higher than other potential investments otherwise these owners will look for returns in other ways.