The meaning of ROE, also known as financial profitability, is the economic benefits obtained from the investments made and the own resources. The ROE concept comes from the expression Return on Equity, which links the net benefits obtained in a specific investment operation with the necessary resources to achieve it.
It is expressed as a percentage and is used to assess the profit achieved on the resources used. Both ROE and financial profitability are used synonymously, although the first is used with accounting data and the second with market data.
To calculate the ROE, the net profit of a company must be divided by its own resources. The end-of-period benefit and own resources at the beginning of the period are used since the intention is to achieve the profitability harvested from resources invested at the beginning of the period.
ROE = Net Profit / Equity
Net profit is understood as the profit obtained after taxes, although there is the possibility that the result of financial profitability is presented as net or gross, depending on whether earnings before or after interest, taxes and other expenses are considered. .
Example of calculating financial profitability
To better understand how to calculate ROE we will use an example. Take the case of a company that makes an investment of 5.000 euros with a return of 10%. This company has financed the operation with own funds worth 2.500 euros and the rest through a credit or loan at a rate of 5% per annum.
This will mean that the return on the investment will be 10% x .5000 = 500 euros.
From the profitability harvested, the cost of the debt contracted with the bank must be subtracted, which granted the loan under the following conditions: 2.500 x 5% = 125 euros.
This means that the net profit of the company for the investment made will be:
Net profit: 500 euros - 125 euros = 375 euros
Thus, the ROE or financial profitability can be calculated:
ROE = 375/2.500 x 100 = 15 euros.