Dictionary and Journal

Return on Equity Dictionary Definitions 2

Interpreting a high result

Basically, a high return on equity is desirable. But a very high value has to be analyzed more and more closely. Where exactly does it come from, how did it come about, how is the company doing as a whole?

Finally, it could also be that the high return on equity was caused by a very low equity ratio . That would mean that the company has little equity and a lot of outside capital . In this case, the return on equity may be high, but there may be massive debt at the same time. Accordingly, in such situations, the high return on equity is associated with considerable risk. In addition, the annual surplus generated must often be used to repay debt and cannot be distributed.

Therefore it is particularly important:

  • never see return on equity as an isolated value.
  • Measure the equity ratio, i.e. the ratio of equity to debt.
  • Analyze the development of the return on equity over time to determine whether the key figure has been temporarily changed by one-off effects or short-term events.

Interpret the low result

A low return on equity can be due to a number of reasons. One option is that the net income for the year has been low. Another possibility is that the equity ratio is simply very high. On the one hand, this ensures financial stability, but it also allows negative conclusions to be drawn. It must also be questioned why the company does not make investments, but rather leaves the capital “unused”. A growing company should have the potential to invest capital in marketing and sales or new production facilities, for example, instead of bunkering it in accounts with no income.

Industry-typical returns on equity

The level of the return also depends on the industries, because different industries are associated with different capital intensity and different common debt capital ratios. With real estate developers, for example, often only a small share of equity is involved, the majority is financed through loans. This quickly results in a high return on equity.
Another example can be traditional medium-sized companies that attach great importance to security and continuity. The equity ratio can be higher here, because security thinking is possibly more important than rapid growth. At the same time, the return on equity falls accordingly.

Leverage effect

When it comes to return on equity, the leverage effect quickly comes into play. This effect describes the fact that the return on equity can be increased as long as the costs of the external capital are lower than the return on the investment by taking on additional new debt.

To put it simply, this means: A company takes on additional outside capital. So the equity ratio is falling. At the same time, the borrowed capital is invested in such a way that the return on the investment is higher than the cost of borrowed capital. The total return therefore increases – and the equity is accordingly more profitable than before.

The leverage effect allows the return on equity to rise through new borrowed capital. The downside is that in a first step, the level of indebtedness goes up accordingly. So it is a risky game and companies need to keep a close eye on the point to which the effect can be used without taking too great a risk.

Critical consideration of the return on equity

In the course of this article, we have already taken a close look at the advantages and disadvantages of this metric. Anyone who takes a critical look at the return on equity will find the following points in particular:

  • An isolated consideration of the key figure is not meaningful.
  • Profitability must be viewed over time – individual years can contain upward and downward outliers.
  • Individual situations in companies and industries must be taken into account; blanket judgments are not possible.
  • There is no “right” value or a specific target value that can be determined as a general ideal value.

Tip!

Accounting software can offer you the option of detailed evaluations of important internal key figures. So you are always up to date and have the current figures of your company constantly in view!

Summary

The return on equity is an important value for investors that has to be considered over the years and together with other key figures. It is important to interpret the calculated result accordingly in order to be able to draw correct conclusions. So it is particularly relevant:

  • Always calculate the return on equity together with other key figures
  • Consider several years
  • Take individual circumstances into account
  • Pay attention to special effects and use the leverage effect – but always keep an eye on the risk

Last but not least, you should never try to increase the returns for your company endlessly with new borrowed capital, but always pay attention to the level of debt.

Return on Equity 2