Managing Return on Equity

For publicly traded companies, one of the most watched financial measurements is return on equity. Return on Equity is calculated by dividing Net Income over Average Shareholder's Equity. Financial Managers break this ratio down into three components for managing the organization. The three components of Return on Equity are: Return on Sales, Asset Turnover, and Financial Leverage. Therefore, we can breakdown Return on Equity as: (Net Income / Sales) x (Sales / Assets) x (Assets / Equity).

Example : Net Income is $ 100,000, Equity is $ 400,000, Sales were $ 500,000 and Assets are $ 600,000. Return on Equity = ($ 100,000 / $ 500,000) x ($ 500,000 / $ 600,000) x

($ 600,000 / $ 400,000) = .20 x .8333 x 1.50 = .25 or 25%.

The trick is to manage these three components in such a way that you maximize Return on Equity. Remember if you increase one ratio, it will decrease a corresponding component. For example, if you were to increase assets, this would increase your leverage (assets / equity), but would decrease your turnover (sales / assets). Additionally, you can further breakdown the three component ratios into more detail ratios. For example, the first component ratio is Return on Sales. This can be broken down into Operating Margin on Sales. The point is to start at the top - Return on Equity and move to the middle layer (3 component ratios) and than move to the bottom layer (detail ratios).