The return on equity (ROE) ratio is calculated by dividing net income after interest and taxes by average shareholder’s equity. We use net income because it gives us an idea about how much income the firm makes after it pays out what is owed to debt holders. What is left over is kept for the firm’s shareholders. It is important to know how much income is kept for the firm’s shareholders in relation to the amount that those shareholders have invested in the firm.
As a result, the difference between a firms return on assets and return on equity is due to the amount of leverage of the firm. We know that return on assets can also be found as a function of the firm’s profit margin and its asset turnover. As a result, the firm’s return on equity can be found as a function of the firm’s return on assets and its equity multiplier.
The intuition from these formulas is that a firm can increase its return on equity by increasing its return on assets or by increasing its equity multiplier. It can increase its return on assets by increasing its profit margin or its asset turnover. It can increase its equity multiplier and its asset turnover by reducing the amount of assets it uses. It can also increase its equity multiplier by reducing shareholder’s equity.
Return on Equity (ROE)
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