🔴 ROE Ratio in 16 min. – How to Calculate Return on Equity Ratio Financial Ratio Analysis Tutorial


ROE Ratio Hi, before this video, you should already
understand the words and concepts found in Financial Statements. These financial statements
are the Balance Sheet and the Income Statement. Welcome back again to MBAbullshit.com. The
topic for this video is ROE: Return on Equity which is one of the Profitability ratios of
Financial Ratio Analysis. Remember, you can always go back to MBAbullshit.com.
This video discusses and analyses the ROE, one of my free videos on Liquidity Ratios
and Profitability Ratios and Market Value Ratios which include these ratios over here.
And after this you can check out my next videos on MBAbullshit.com such as my video on Financial
Leverage Ratios which include these ratios over here and my other video on MBAbullshit.com
about Turn-over Ratios which includes all of these Ratios over here, down here.
Let’s get down to it. Let’s start with a story, let’s say that ABC Company has
$1000 in Net Income per year and $3000 in Equity. What is the Return Equity or ROE?
Very simple, the ROE is $1000 divided by $3000. Where do you get this $1000? $1000 in Net
Income per year based on the most recent year earnings or the last year’s earning. Where
do we get the $3000? It’s a $3000 in Equity. We divide the nominator by the denominator
and we get an ROE of 0.33 or 33%. What does this mean? Well, this simply means that for
every $100 the company owners have in Equity it makes $33 in profit. The company makes
$33 in profit for every $100 of the company owners have in Equity. Therefore, a higher
ROE is considered better. A higher ROE indicates that the company is more efficient in giving
more profit to the company’s owners compared to these owners’ investment, personal investment
in the company. Now, lower ROE indicates that the company
is less efficient in giving more profit to the company’s owners compared to their investment
into the company of their personal money into the company. Now there are still some important
flaws in using this Ratio. Some things which make it not perfect or some will even say
make it wrong to use it. First of all, a high ROE does not necessarily mean a high cash
flow. Why? Because the ROE formula uses profit instead of cash flow. Remember, Financial
Managers prefer Cash Flow instead of Profit. Your company might have a ROE because of high
accrued sales meaning sales, you know you make a sale but then your customer hasn’t
paid you yet. That’s an accrued sale and that will increase your profit without increasing
your cash flow. Your company might have a high ROE because of high accrued sales and
not cash sales or, yeah, and or the cash from these sales might be paid to the company too
far into the future. It’s important to note that. Conversely, a low ROE may be the result
of high asset value from previous’ years intense profitability, and maybe you’re
just taking a breather for this year or last year. Remember in computing the ROE you use
the most recent years’ earnings. Maybe you’re just taking a breather last year but then
your company continues to grow fast the big profits.
Thirdly, Equity is based on the Asset, how do you compute Equity? Assets minus liabilities.
How do you value the assets in that case? It’s based on book value and not real market
value. For example, what part of the assets of your company is a building or a car; maybe
if you try to sell that building or a car, you might be able to sell it for 1 million
dollars. But your accountant wrongly, no I don’t really say wrong, wrongly in quotation
marks, wrongly values it at 2 million because it was bought at 3 million and after subtracting
depreciation, they decided the book value is 2 million. But in the real world you could
only sell it for 1 million. In that case, the market value is different from the book,
the real market value is different from the book value which is in a way is wrong compared
to the market value. Because it is not based in the real value that you could sell the
asset instead it is just based in some accounting rules. It’s important to note that. And
fourthly, very important, is that the owner’s actual investment.
Remember, I said earlier that a high ROE means that you’re earning a lot of profit, the
owner is earning a lot of profit compared to his personal investment in the company
which is based on Equity but in reality is the owner ‘s actual investment maybe based
on stock value not simply based on Equity. This not simply based on assets minus liabilities.
What is assets minus liabilities? This means Equity, right? How do you measure how much
is the personal investment of an owner into a company? Is it based on Equity? Well, accountants
or the balance sheet will measure an owner’s personal investment into the company by looking
at the value of the Equity but in reality the owners of the company or the owner s of
the shares of the company did not invest this amount into the company. How much did they
invest in the company? Well, it depends on what price they bought the stock in the stock
market and that is the stock value. Unfortunately, when we compute ROE we use equity, the value
equity instead of a more real investment value, which is stock value, which in some sense
would be better. That’s a flaw or should I say that shows where this ROE is weak. The
owner’s actual investment might really be based on stock value but the ROE does not
take to accounts stock value and instead takes into account equity which more a balance sheet
figure rather than the real investment of the owner.
Now let’s analyse the ROE from the traditional stand point. First of all, you would compare
the ROE of a company to historical ROE. ROE is higher now than in previous years that
it indicates that the company this year is better at creating profits for its owners
compared to their personal investment. But like I said, the flaw here is that this personal
investment is valued using the value of equity instead of stock value which is probably more
correct or could be more correct. But anyway, traditionally, a higher ROE now means that
the company is better at creating profits for its owners compared to their personal
investment this year. If the ROE is lower now than last year’s then this indicates
that the company this year is not as good at creating profits for its owners compared
to their personal investment. Traditional Analysis number two, is to compare
the ROE of this company to the ROE of other similar companies in the same industry or
in similar industries. If the ROE is higher than theirs than the other companies, then
it indicates that this company has better ability to give profit to owners compared
to owners’ investments or that this company is better than other similar companies in
giving profit to owners compared to the owners’ investments. In other words this company is
giving a better deal than other companies, not a better deal to customers, it’s giving
a better deal to the owners of the company because the owners get back a much larger
profit compared to their own investment into the company. Unlike with other company which
might give less profit compared to owners investments in those companies. If the ROE
of this company is lower than theirs then when I say theirs, I mean other similar company
then these indicates better ability of your company or no, not better ability, its lousier
abilities, its worst abilities sorry. This indicates worst ability of your company to
give profit to owners’ compared to owners investments compared to the other companies,
the other similar companies. This company is giving a worst deal than other company,
a worst deal to owners compared to other companies which are giving a better deal to their owners.
Now, I’d like to include some important tips when using this Ratio. First tip to remember,
now this is necessarily a tip on what to do. It’s a tip on what to think about when you’re
using this Ratio. Take note that to increase ROE Return Equity on Financial Manager can
simply manipulate the books to get a higher ROE. How? By simply reducing equity of the
company. How can you reduce equity? By increasing the proportion of debt. Because remember,
Equity is equal to assets minus liabilities. If the Financial Manager increases the liabilities,
you will have a smaller amount of Equity. And if you have a smaller amount of Equity,
then the profit of the company would look big compared to the small Equity. And when
the profits of the company look big compared to the small equity, you will end up with
a higher ROE. A higher ROE again is not necessarily good, it could be because the financial Managers’
manipulating things around to make the ROE look bigger. Now you might say, “What’s
wrong with that? What’s wrong with increasing the liabilities to get bigger ROE?” Well,
nothing is wrong, but it’s just something to think about because increase debt will
increase interest expense and may therefore reduce profit and when you reduce profit you
also reduce your ROE in the longer term, in the long run you will have a lower ROE or
you might end up with a lower ROE. The second tip I’d like to share is that, increasing
ROE by increasing debt also increases the risk of the company because higher debt also
means higher risk. If you like to go deeper into this concept
at higher debt means higher risk, I suggest you look at my other videos at MBAbullshit
on CAPM or the cost of equity and another video at MBAbullshit.com about levered versus
unlevered data. But for now, simply believe me when I tell you that increasing debt also
increases the risk of the company. And the increase in ROE may not be worth the increase
in this risk. There, I hope you learned something or remember to share it if you like it. Follow
me in twitter, look for MBAbullshit or join my fan page in Facebook for the latest updates
on my latest videos coming out. I usually say it on Facebook or whenever I have a new
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links on your email or on your other social media. Have a great day and goodbye. debbierojonan Page 1

Paul Whisler

23 Comments

  1. Thanks 19Excel! Remember to share with your friends. Cheers!

  2. Hey DJ, ROI is just a broader term, in which "I" or "investment" can have many meanings. In some cases, ROI can be the same as ROE…

  3. I have a question: how do you find ROE with total assets = $240,000 ; debt-to-equity ratio = 0.60 and ROA = 9%
    Thanks.

  4. Dear sir, should i include non-controlling interest in total equity when computing ROE and equity ratio if i am an investor? Thank you.

  5. Hi.
    If liabilities are increase by $1000 assets will increase by $1000 too, and the equty will be the same… How can managers manipulate.
    When we calculate the ROA we take the equity at the end of past period. This is the past, how can we change the past?
    We can change the current year gain only, by decreasing or increasing some costs/profits
    It's my view.. Thx.

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