How to Calculate and Analyze Return on Equity

How to Calculate and Analyze Return on EquityWhen it comes to evaluating a business, especially one that is publicly traded, determining its return on equity (ROE) is one way to see how it’s performing.

What is Return on Equity?

Return on equity is a ratio that gives investors insight into how effectively the company’s management team is taking care of the shareholders’ financial investments in the company. The greater the ROE percentage, the better the business’ management staff is at making income and creating growth from shareholders’ investments.  

How ROE is Determined

In order to calculate ROE, a company’s net income is divided by shareholder equity. To arrive at net income, businesses account for the cost of doing business, which includes the cost of goods sold, sales, operating and general expenses, interest, tax payments, etc. and then subtracts these costs of doing business from all sales. Similarly, the free cash flow figure can be substituted in place of net income.

There are some caveats when it comes to calculating net income. It is determined prior to paying out dividends to common shareholders, but loan interest and preferred shareholder dividend obligations must be met before starting this calculation.

The other part of the equation is the shareholder equity or stockholders’ equity. One definition is to subtract existing liabilities from a business’ assets, and what remains is what owners of a corporation or its shareholders would be able to claim as their equity in the company. Whether it’s done year over year or quarter over quarter, traders and investors can see how well a company performs over different time periods.

Return on equity is also able to be determined if a business’ net income and equity are in the black. The net income is found on the income statement – the ledger of the company’s financial transactions. Shareholders’ equity is found on the balance sheet – which details the business’ assets and financial obligations.

Analyzing a Business’ ROE

Another consideration that industry experts recommend to determine if a company’s ROE is poor or excellent is to see how it compares to the S&P 500 Index’s performance. With the historical rate of return being 10 percent annually over the past decade, and if a ROE is lower than 10 percent, it can give a good indication as to a particular business’ performance. However, a particular company’s ROE also needs to be compared against the industry’s ROE to see if the company is outperforming its sector.

For example, according to Yahoo Finance!, the ROE on Microsoft’s stock is 42.80 percent. This means that the management team running Microsoft is returning just shy of 43 cents for every dollar in shareholders’ equity. Compared to its industry (Software System & Application) ROE of 13.47percent – as cited by New York University’s Stern School of Business – Microsoft has a much higher ROE compared to the industry average. This is just one metric to measure the company’s performance, but it is an important one.

While looking at a company’s return on equity is not the end all or be all, it’s a good start to determine a company’s present and future financial health.

Sources

https://us.spindices.com/indices/equity/sp-500

https://finance.yahoo.com/quote/MSFT/key-statistics?p=MSFT

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/roe.html

Furniture, Fixtures and Equipment – and Depreciation

When it comes to determining depreciation for Furniture, Fixtures and Equipment (FF&E), there are many considerations that exist for accountants and business owners.

Defining Furniture, Fixtures and Equipment

FF&E refers to expenses for business items that are not affixed to the building where that business operates. Real world examples of depreciable assets includes chairs, desks, phones, tables, cabinets, etc., which are used to perform business-related tasks, directly or indirectly. These types of items are associated with long-term use generally more than 12 months, according to the Internal Revenue Service.

Understanding How It Works

When it comes to accounting for the expense of the item, it can be depreciated equally and discreetly over its useful life. According to the IRS’ General Depreciation System (GDS), these office items such as safes, desks and files, are expected to have a seven-year life.

While there are different approaches to calculate depreciation, a common way to do so is through straight-line depreciation. This method is used by many organizations, including The Federal Reserve, and it works by starting with how much the item cost to acquire or its adjusted basis. From there, the item’s cost is reduced by the salvage value, or the asset’s value after its useful life. The resulting figure is divided by the number of months of the asset’s useful life. Once the asset has exhausted this amount of time, it remains on the books as its salvage value until it’s sold or removed from service.

Using the straight-line method, a company might find the monthly depreciation charge for a truck purchase like this. The company purchases a new truck for $40,000; assuming a 60-month useful life allowable by the IRS and a 20 percent salvage value, the formula would be as follows:

  1. $40,000 – (20 percent x $40,000) / 60 months
  2. $40,000 – ($8,000) / 60 months
  3. $32,000 / 60 = $533.33 per month for monthly depreciation

Special Considerations

In addition to tangible property, some intangible property also can be depreciated under the right circumstances. Examples the IRS cites of this primarily intellectual property includes copyrights, patents and software. Conditions for depreciation of this type of intangible property include that it must be owned by the business owner, used within the business or for profit-related activities, have a useful life and can be used by the business for more than a year.

The IRS gives an example of an individual buying a patent for $5,100. Using the straight-line method, the IRS permits this type of non-section 197 intangible property to be depreciated under certain conditions. The owner then must reduce any salvage value from the non-section 197 intangible property’s adjusted basis and depreciate it over the patent’s useful life, prorating terms less than a year, if applicable.  

Eligible Intangible Property Example

Assume the individual bought a patent in May to be used starting June 1 of the same year. The patent was bought for $5,100, has a 17-year useful life and won’t have any salvage value.

The first year of depreciation must be prorated for six months, since it will be used from June to December of the first year. Taking these circumstances and rules from the IRS, the first year’s depreciation available is $150. Each subsequent year, the 16 remaining will be $300 each.

While there are many intricacies for depreciation, understanding how it applies to each business’ operations will help give a fair assessment of an equipment’s value.

Sources

https://www.irs.gov/pub/irs-pdf/p946.pdf