21 Calculating Return on Equity
Learning Objectives
- Calculate and interpret leverage ratios.
Leverage Ratios
Financial leverage refers to the use of debt to acquire additional assets. Although most companies require some type of financing to start, expand or continue their operations, these leverage ratios inform potential creditors of the potential risk associated with extending credit to the business. Business’s that carry a heavy debt load run the risk of over-extending themselves to the point that funds are not available for the key functions of the business.
- Debt Ratio. The debt ratio measures the percentage of the company’s total assets that are financed by creditors and lenders as opposed to the owners. The debt ratio is calculated as follows:
Debt Ratio= (Total Debt or Liabilities)/(Total Assets)
Total debt includes all current liabilities and any outstanding long-term debt such as loans, notes or bonds. The total assets include all of the company’s current assets, fixed assets and any intangible assets such as goodwill. Business owners prefer a higher debt ratio than lenders because the higher debt ratio reflects that the owner has less invested in the business and consequently has less to lose.
- Debt-to-Net-Worth Ratio. This ratio also expresses the relationship between the capital contributions of the owners and the capital contributed by lenders. It is fundamentally the ratio of what the business is worth compared to what the business owes.
Debt-to-Net-Worth Ratio= (Total Debt or Liabilities)/(Tangible Net Worth)
In this ratio total debt includes both current and long-term liabilities as was the case with the Debt Ratio. However, in order to calculate the Debt-to-Net-Worth ratio we must derive the tangible net worth of the business. The tangible net worth of the business represents the owner’s investment in the business less any intangible assets. We find tangible net worth as follows: Owners Capital + Capital Stock + Earned Surplus + Retained Earnings – Intangible Assets (such as goodwill). A high Debt-to-Net-Worth ratio indicates that the company is highly leveraged and will make it difficult for a business to borrow funds since lenders will consider them “maxed out” when it comes to borrowing.
- Times-Interest-Earned Ratio. This ratio is the measure of a business’s ability to make its interest payments on borrowed capital. In literally tells the business how many times their earnings will cover the interest payments on the loans it is carrying. It is calculated as follows:
Times Interest Earned Ratio= (EBIT (Earnings Before Interest & Taxes))/(Total Interest Expense)
EBIT is the company’s profit after deducting all expenses but before deducting interest expense and income tax. A high Times-Interest-Earned Ratio indicates that the company has little trouble making its interest payments and generally lender prefer a ratio of at least 2:1. It is not unusual for lenders to require this ratio to be as high as 6:1 if the business is a start-up or very young.
Return on Equity is the measure of both profit and efficiency. An increase in ROE over time is a good thing for a business. However, some industries tend to ROEs in a specific range so it’s important to compare companies from the same industry.
ROE= (Net Income)/(Shareholder’s Equity)
