The Return on Equity Ratio in Financial Accounting

Topic: Accounting
Words: 285 Pages: 1

The primary goal of finance is to identify the best way to get the money necessary to purchase resources and allocate them efficiently. Financial accounting gathers and reports information for investors and creditors, providing them with financial statements. Such statements’ analysis includes credit analysis, regulatory uses, loan covenants, and performance evaluation. After assessing the financial statements, companies decide on product costs, budgeting, investments, and several project lines. If shareholders need to determine practical and unbiased business value, they refer to financial statements: income statement, balance sheet, statement of cash flow, and statement of shareholders’ equity.

Return on equity (ROE) is the central ratio in calculating a business’ profitability. It measures the amount of profit earned per dollar of investment. It helps investors to determine their revenues from investments they make. Moreover, it is a way to assess the efficiency of utilization of the firm’s equity. Thus, the accountant divides net income by the stockholder’s equity to calculate return on equity. The higher the ratio, the more effective the financial strategy.

Sometimes companies disintegrate ROE into two: return on operating and non-operating activities (Dowdell et al., 2020). The first is computed using the balance sheet’s net operating assets and liabilities. Meanwhile, the second uses the percentage of net non-operating obligations. This ratio separation helps identify the exact value created through the company’s core operations. Operational return on equity reveals ineffective inventory management because it incorporates lower inventory turnover ratios. Return on equity with values between 15% and 20% is appropriate (Dowdell et al., 2020). It illustrates that the company can efficiently use available equity to manage to generate high profits. To conclude, return on equity is a significant indicator of how the firm uses its capital.

Reference

Dowdell, T. D., Klamm, B. K., & Andersen, M. L. (2020). Internal controls and financial statement analysis. Journal of Theoretical Accounting Research, 15(2), 34–57.

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