Return on Equity Financial Ratio in QuickBooks - dummies

Return on Equity Financial Ratio in QuickBooks

By Stephen L. Nelson

The return on equity financial ratio expresses a firm’s net income as a percentage of its owner’s equity or shareholders’ equity. (Shareholders’ and owner’s equity are the same thing.)

The formula, which is deceptively simple, is as follows:

net income/owner's equity

Assume that a business has a net income equal to $50,000, and the owner’s equity equals $200,000. This firm’s return on equity, therefore, can be calculated by using the following formula:

$50,000/$200,000

This formula returns the value of 0.25, which means that this firm’s return on equity is 25 percent — a number that’s probably pretty good.

No guideline exists for what is and isn’t an acceptable return on equity. However, here are two useful observations about how you should interpret the return on equity ratio that you calculate:

  • The return on equity ratio that you calculate needs to be at least as good as you deserve. Okay, that sounds circular. So think about it this way: If you’re investing money in your business, you deserve a return on that money. And that return needs to be reasonable compared with your other alternatives.

    If you can go out and invest money in a stock market mutual fund and get 10 percent, you shouldn’t be investing in things that deliver a return of less than 10 percent. That makes sense, right?

    Therefore, if you want to earn a 20 percent return on the money that you’ve invested in your own firm (by the way, a 20 percent return is a very reasonable return for a small business), you want to make sure that your return on equity (after you get going) exceeds this minimum return.

  • The return on equity ratio hints at the sustainable growth rate that your firm can manage. This sounds complicated. However, you need to understand what sustainable growth is and how it ties back to the return on equity ratio.

    Sustainable growth is the growth rate that your business can sustain over a long period of time: three years, five years, ten years, and so on. If you don’t take money out of the business (other than your salary), and you reinvest the return on equity that the business generates, the return on equity ratio equals your sustainable growth.

    In other words, the example business described earlier in Tables 1-1 and 1-2 can grow on a sustained basis as fast as 25 percent.

Alternatively, suppose that the owners of the imaginary firm described in the financial statements in this chapter take half the equity money out of the business. Perhaps half the $50,000 net income is distributed as a dividend to shareholders, for example.

In this case, because only half the return on equity is reinvested, sustainable growth equals only half the return on equity percentage. If the return on equity percentage equals 25 percent, but the owners withdraw half the return (12.5 percent), the reinvested half of the return on equity percentage (12.5 percent) equals the sustainable growth rate. In other words, this business can grow on a sustained basis at 12.5 percent annually.

This sustainable growth business makes intuitive sense to some people, but it just leads to head-scratching for other people. In case you’re in the head-scratching group, consider a couple more comments:

  • Growing sales and profits also requires growing your capital structure. The idea of a sustainable growth rate (which was pioneered by Hewlett-Packard, interestingly enough) is based on an intuitively understandable proposition: To grow your sales and your profits over the long run, you need to grow your assets.

    If you’re going to double your sales and your profits, for example, you’re probably going to have to double your assets. And if you double your assets, you must double your funding of those assets. Doubled funding of your assets means that you double your borrowing and your owner’s equity.

    Assuming that you can get creditors to loan you more money — that should be possible if you’re growing not only sales, but also profits — you still need to double your owner’s equity. And the way that you usually double or grow your owner’s equity in a small business is by reinvesting the return on the equity.

    Large businesses have another way to grow owner’s equity. A large business, such as Hewlett-Packard, can go out into the capital markets and raise money by issuing stock. In fact, the real reason for making a company public isn’t to make the owners rich, but to access the public’s capital markets.

    Those markets provide access to almost unlimited amounts of capital (that is, unless you pull an Enron or WorldCom by proving that you don’t really deserve access to the capital markets). In the case in which a firm can tap these capital markets for cash or funding, the sustainable growth rate formula gets more complicated. These capital markets provide another way to grow owner’s equity.

  • If you don’t grow owner’s equity as your business grows, watch out. You’ll have big problems if you ignore the sustainable growth rate and your business grows fast. If you don’t grow your owner’s equity at least as fast as your business grows, your debt percentage ratio skyrockets (perhaps) without your even realizing it.

    Just think about this logically: If your sales double, your assets probably double. And if your owner’s equity doesn’t double, creditors have to make up the difference. Exploding debt means that it becomes all the more important for you to refinance that debt and refinance even larger amounts of that debt. And exploding debt means that your interest expense is growing all the time because your debt levels are rising.