Return on equity is the most important indicator of the efficiency of an enterprise. Like other indicators of profitability, it is a relative value and determines the return on equity.
Instructions
Step 1
The return on equity indicator characterizes the amount of profit that the owners of the enterprise receive on their capital invested. It is calculated as the ratio of the profit remaining at the disposal of the company, multiplied by 100, to the amount of equity capital (Section III of the balance sheet). The dynamics of this indicator affects the level of the company's stock quotes and shows the quality of the advanced capital management.
Step 2
If we compare the return on equity with the level of return on assets, then we can determine the efficiency of the use of financial leverage by the enterprise (loans and borrowings). The return on equity capital grows if the share of borrowed funds in the volume of formed assets increases. The difference between return on equity and return on total equity is the leverage effect. In other words, this is an increase in the return on equity by attracting borrowed funds (credit).
Step 3
When analyzing the profitability of equity capital, they use such a concept as a leverage. It represents the share of attracted sources of financing in the amount of funds for forming the assets of the enterprise. The ratio of the sources of property formation will be optimal if an increase in the return on equity capital is ensured along with an acceptable amount of financial risk.
Step 4
Therefore, sometimes it is advisable for an organization to use borrowed funds (loans), even if the amount of the company's own capital is sufficient to form property. This is due to the fact that the effect of the use of borrowed funds, expressed in the growth of the return on equity, may be higher than the interest rate for the use of these funds.
