Return on equity is an important measurement for investors to use when comparing similar companies to decide where to invest. It is measured by dividing a company’s net income by its shareholders' equity to determine if the initial investment gained any profit. A higher ROE indicates a company’s ability to use money invested to benefit the company and its investors. The major difference between a levered ROE and an unlevered ROE is how various borrowed funds are accounted for. Levered ROE includes various types of borrowing, while unlevered ROE is strictly a measure of shareholder and investor-based funding.
While levered ROE incorporates varies loans and borrowing, unlevered ROE relies strictly on funding from shareholders and investors.
Unlevered Return on Equity
Unlevered ROE is a straightforward metric for examining how well a business will profit its investors. Investors and shareholders expect their money to grow with the company, but as with all investments, nothing is without an element of risk.
The decisions a business makes regarding the investments will directly impact the annual ROE, and it is necessary to measure how those investments were used in order to maintain the current investments and to secure new investments for the following year. Without a positive ROE or a greater ROE than its competitors, a business runs the risk of losing investors altogether.
Levered Return on Equity
Levered ROE is different in the way that it uses a loan to increase its overall profit for that fiscal year rather than depending on investments alone. This approach may best be used for businesses that are starting out if it has not been able to secure enough initial investments to get started, but increasing debt also runs a much greater risk to any business’s profit margin.
If a business has been losing investors due to poor performance, it may get a loan to help maintain or increase its profits; however, it’s always wise to look at the cause of fleeing investors prior to throwing more money at a problem. Rather than taking out a loan to maintain its current operations, a business may be better off downsizing, selling off assets and communicating with its remaining investors to increase overall profit and trust.
Making the Necessary Calculations
It’s always important to take a company’s debts into account when examining the overall ROE. For example, if a company received $5,000 from shareholders' equity and reports $10,000 in net income for that fiscal year, then the ROE would be 2, essentially doubling the investors’ money.
However, if this same company also took out a loan of $5,000 during that fiscal year, then that loan would need to be included among the company’s assets, which would calculate to a ROE of 1. In this instance, the ROE may not be a complete picture of a company’s overall health or use of funds if the company took out a loan to contribute to the overall net profit.
- What Is Retained Earnings on a Balance Sheet?
- What Happens If a Company Doesn't Pay Dividends to Stockholders?
- How to Calculate Leverage Ratio
- How to Calculate a Required Return of a Preferred Stock
- How to Calculate Equity Return
- What Is the Purpose of an IPO?
- The Advantages of Buying Undervalued Stock
- What Is the Importance of Investor Ratios?