Return on Equity is the ratio of net income to equity or net assets (i.e assets - liabilities)
ROE = Net income /(Total Assets - Total liabilities)
If the denominator (Assets) rises at a higher rate than the numerator (PAT), ROE will fall, despite rise in profits.
If a company having rising profits and debts starts to reduce its high debt burden by paying off the debt at a fast pace, the liabilities of the company will start reducing and this will be mostly by the excess cash profits generated by the rising PAT levels. This indicates that the assets may still remain high and the denominator inturn will increase. This situation will lead to falling ROE even when profit increases.
E.g for a company
Let us assume PAT (a) increases from 20,00,000 to 30,00,000 from FY18 to FY19.
Total Assets (b) increases from 5,00,00,000 to 6,00,00,000 for the same period
Total liabilities (c) reduced from 3,00,00,000 to 2,75,00,000
Shareholders capital (d) = b - c ; increased from 2,00,00,000 to 3,25,00,000
ROE (a/d) decreased from 10% to 9.2%.
In the above example ROE has fallen despite the PAT rising because of the lower liabilities and higher assets in the balance sheet. Thus while analysing the company's ROE an investor should keep a watch on the assets and liabilties of the company to understand the accurate reason for change.
ROE = Net income /(Total Assets - Total liabilities)
If the denominator (Assets) rises at a higher rate than the numerator (PAT), ROE will fall, despite rise in profits.
If a company having rising profits and debts starts to reduce its high debt burden by paying off the debt at a fast pace, the liabilities of the company will start reducing and this will be mostly by the excess cash profits generated by the rising PAT levels. This indicates that the assets may still remain high and the denominator inturn will increase. This situation will lead to falling ROE even when profit increases.
E.g for a company
Let us assume PAT (a) increases from 20,00,000 to 30,00,000 from FY18 to FY19.
Total Assets (b) increases from 5,00,00,000 to 6,00,00,000 for the same period
Total liabilities (c) reduced from 3,00,00,000 to 2,75,00,000
Shareholders capital (d) = b - c ; increased from 2,00,00,000 to 3,25,00,000
ROE (a/d) decreased from 10% to 9.2%.
In the above example ROE has fallen despite the PAT rising because of the lower liabilities and higher assets in the balance sheet. Thus while analysing the company's ROE an investor should keep a watch on the assets and liabilties of the company to understand the accurate reason for change.
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