Return on Equity Ratio (1 Viewer)

[Examine]

What are your opinions on this. In various textbooks, it can be gathered that there are two options which you can take while calculating this ratio. Without having and clear answer on which one is right, I have resulted in asking BoS. All opinions are accepted, from what you have learnt from uni or if you are also doing the HSC course this year, or have done it before.

Option 1: Return on equity ratio = net profit / total equity (including everything under the Owner's equity section of a balance sheet)

Option 2: Return on equity ratio = net profit / capital (as this is what the owner has invested into the business)

 

[seremify007]

I'd say it's net profit or earnings divided by total equity. That is, to include all other forms of equity such as retained earnings (undistributed profits).

The point of the ROE calculation is to figure out how much profit can be generated with the net assets or equity in a business (i.e. the assets or investments of the shareholders) for a period of time.

In the context of analysing returns on equity, to divide only by the initial capital contribution would be fundamentally flawed in that it is not taking into account other forms of equity/residual interests which belong to the same shareholders/owners. For example, a company with assets of $200, liabilities of $100, owners equity of $80 and retained earnings of $20 would have different ratios if you were to use owners equity/capital of $80 rather than total equity of $100. Given that the retained earnings of $20 is technically owned by the owners but just is in the form of undistributed profits, it doesn't make sense to exclude it from the denominator.

Looking at it from another point of view, if you put $100 into a bank account earning 20% per annum interest. After one year you would have $120, and after two years (assuming you reinvest the interest and don't withdraw any; and no tax implications), you would have $100*1.2*1.2 = $144. What would your return on equity be in the 2nd year? It should be ($144-$120)/$120 as you need to take into account the amount you reinvested and did not take out of the bank account.

Apologies if this doesn't make sense- I can rethink about it when I'm more awake if it helps.

 

[Examine]

I'd say it's net profit or earnings divided by total equity. That is, to include all other forms of equity such as retained earnings (undistributed profits).

The point of the ROE calculation is to figure out how much profit can be generated with the net assets or equity in a business (i.e. the assets or investments of the shareholders) for a period of time.

In the context of analysing returns on equity, to divide only by the initial capital contribution would be fundamentally flawed in that it is not taking into account other forms of equity/residual interests which belong to the same shareholders/owners. For example, a company with assets of $200, liabilities of $100, owners equity of $80 and retained earnings of $20 would have different ratios if you were to use owners equity/capital of $80 rather than total equity of $100. Given that the retained earnings of $20 is technically owned by the owners but just is in the form of undistributed profits, it doesn't make sense to exclude it from the denominator.

Looking at it from another point of view, if you put $100 into a bank account earning 20% per annum interest. After one year you would have $120, and after two years (assuming you reinvest the interest and don't withdraw any; and no tax implications), you would have $100*1.2*1.2 = $144. What would your return on equity be in the 2nd year? It should be ($144-$120)/$120 as you need to take into account the amount you reinvested and did not take out of the bank account.

Apologies if this doesn't make sense- I can rethink about it when I'm more awake if it helps.

It makes sense, I use the method you stated too, just wanted other opinions. Thanks for the response!

 

[Kezza1]

Hi examine. Just checking what you said. You called bos and they responded either answer is accepted as correct?

 

[Examine]

Hi examine. Just checking what you said. You called bos and they responded either answer is accepted as correct?

Hey,

I don't recall tbh, though they provide the ratios in the exam anyway (as seen from 2012) so just use what they supply.