# Explain Return on Equity Capital With Examples

### Reviewed by Subject Matter Experts

Updated on March 30, 2023

## Return on Equity Capital: Explanation

Equity shareholders are the real owners of a company. They bear all the risk, whereas preference shareholders have priority of payments of dividends and as well as capital.

The rate of dividend on equity shares differs from year to year depending upon the amount of profit. A company's performance is judged based on the amount of return on equity capital.

## Formula For Return on Equity Capital

To calculate return on equity capital, use the following formula:

Return on equity capital = (Net profit after tax - Preference dividend) / Equity share capital

## Example

Calculate the return on equity capital using the following information:

 10,000 shares of \$100 each, \$80 paid 800,000 12% 5,000 preference shares of 50 each 250,000 Profit before tax 400,000 Rate of tax 50%

### Solution

ROE = (Net profit after tax - Preference dividend) x 100 / Equity share capital paid up

 Profit 400,000 Less tax 50% 200,000 Profit after tax 200,000 Less preference dividend 12% (250,000) 30,000 170,000

ROE = 170,000 (Net profit after tax - Preference dividend) x 100 / 800,000

= 21.25%

Comment: This ratio is useful for equity shareholders who want to know how profitable the company is, thereby determining the size of the dividend they will receive.

## Earnings Per Share (EPS)

The shortcut for calculating EPS is to divide profit after tax and the preference dividend by the number of shares.

### Example

Continuing with the details from the first example:

EPS = 170,000 (Net profit after tax - Preference dividend) x 100 / Number of equity shares

= 170,000 / 10,000 = \$17 per share

## Current Assets Movement or Efficiency Activity Ratio

These ratios are also known as turnover ratios because they indicate the speed at which assets are converted into sales. These ratios are calculated on sales.

Inventory turn over ratio = Cost of sales / Average Stock

Opening Stock = (Opening Stock + Closing stock) / 2

### Example

Consider the following information:

Opening stock = \$20,000

Closing stock = \$10,000

Purchases = 50,000

Carriage on purchases = 5,000

Sale = \$1,00,000

Required: Calculate the stock turnover ratio (STR), which is equal to the cost of goods sold divided by the average stock.

### Solution

Cost of goods sold = Opening stock + Purchase + Carriage - Closing stock

= 2,00,000 + 50,000 + 5,000 - 10,000 = 65,000

Average stock = (Opening stock + closing stock) / 2

= (20,000 + 10,000) / 2

= \$15,000

Therefore, the stock turnover ratio is 65,000 / 15,000 = 13:3

Comment: This ratio shows how many times a company's stock has been purchased in the course of the year.