Advantages and Disadvantages of Return on Equity Ratio

Return on equity (ROE) is a financial ratio that measures a company’s profitability by evaluating the amount of net income generated in relation to the company’s shareholder equity.

It is a widely used metric in accounting and finance, as it provides insight into a company’s ability to generate profits from its shareholders’ investments.

The ROE ratio is calculated by dividing a company’s net income by its shareholder equity. A high ROE ratio indicates that a company is generating a significant amount of profit from its shareholders’ investments. A low ROE ratio may indicate that the company is struggling to generate profits.

The return on equity ratio is considered to be one of the most important financial ratios because it measures a company’s ability to generate profits from its shareholders’ investments.

It is important to note that the ROE ratio can vary greatly across different industries and sectors. For example, companies in the technology industry may have a higher ROE ratio than those in the manufacturing industry because of the lower capital requirements and higher profit margins in the technology sector.

Therefore, it is important to compare a company’s ROE ratio to those of other companies in the same industry or sector to get a more accurate picture of its performance.

Formula

Return on Equity = Net Income / Total Share Equity

• Net Income: It is the profit that remain after all expenses deduct from revenue.
• Total Equity: it is the portion of a company’s assets that belongs to its owners or shareholders. We can calculate by deducting total liabilities from total assets.

Advantages of Return on Equity

• Easy to calculate: We can get the ROE with a simple calculation. The net income and total equity can be get from the financial statements.
• Comparability: The ROE ratio can be used to compare the performance of different equity investments. By comparing the ROE ratios of different companies in the same industry or sector, investors can identify which companies are generating the highest returns on their shareholders’ investments.
• Forecast the growth rate: The ROE ratio can be used to estimate a company’s growth rate. A consistently high ROE ratio over several years may indicate that a company has a strong business model and a high potential for growth.
• Assessing a company’s sustainability: The ROE ratio can also be used to assess a company’s sustainability. A consistently high ROE ratio over several years may indicate that a company is well-managed and has a sustainable business model, while a consistently low ROE ratio may indicate that the company is struggling and may be at risk of financial distress.
• The use of equity: The ROE ratio can be used to evaluate how efficiently a company is utilizing its equity. A high ROE ratio indicates that the company is using its shareholders’ investments effectively and efficiently, while a low ROE ratio may indicate that the company is struggling to generate profits or that it has a high level of debt.

Disadvantages of Return on Equity

• Does not work with net loss: The ROE ratio is calculated by dividing a company’s net income by its shareholder equity. As a result, the ratio only works for companies that have a positive net income and does not provide an accurate measure of performance for companies that have a net loss.
• Difficult to compare: The ROE ratio can vary greatly across different industries and sectors, so it can be challenging to compare the ratio of one company to another. For example, companies in the technology industry may have a higher ROE ratio than those in the manufacturing industry because of the lower capital requirements and higher profit margins in the technology sector.
• Not suitable for start-ups company: The ROE ratio is not suitable for start-ups with high equity and low income. This is because start-ups tend to have higher equity and lower income due to the high costs of setting up and running the business.
• Manipulation: The ROE ratio can be affected by accounting policies and manipulation. Different accounting policies such as depreciation, amortization, and inventory valuation methods can result in different net income figures and affect the ROE ratio.