The return on equity ratio reveals the amount of return earned on the shareholders' equity invested in a business. The measurement is commonly used by investors to evaluate current and prospective business investments. This return can be improved when a business buys back its own stock from investors, or by using more debt and less equity to fund its operations.
To calculate the return on equity, simply divide net income by the total amount of equity. The formula is:
Net income ÷ Equity
The numerator can be modified to only include income from operations, which yields a better picture of the value generated by the operational capabilities of a business, with all financing issues stripped out.
The use of debt to buy back stock and thereby increase the return on equity can backfire. The new debt brings with it a new fixed expense in the form of interest payments. If sales decline, this added cost of debt could trigger a steep decline in profits that could end in bankruptcy. Thus, a business that relies too much on debt to enhance its shareholder returns may find itself in significant financial trouble.
Return on Equity Example
The president of Finchley Fireworks has been granted a bonus plan that is triggered by an increase in the return on equity. Finchley has $2,000,000 of equity, of which the president plans to buy back $600,000 with the proceeds of a loan that has a 6% after-tax interest rate. The following table models this plan:
|Before Stock Buyback||After Stock Buyback|
|Debt interest expense||---||36,000|
|Return on equity||15%||19%|
The model indicates that this strategy will work. Expenses will be increased by the new amount of interest expense, but the offset is a steep decline in equity, which increases the return on equity. An additional issue to be investigated is whether the company's cash flows are stable enough to support this extra level of debt.
The type of financial engineering described in the example to improve the return on equity should be periodically re-examined, to account for any changes in the underlying fundamentals of the business.