Return on equity is a comparison of a company's profit to its shareholders' equity. A high return on equity is among the signals of strong financial performance. Factors that affect changes in ROE include positive or negative revenue changes as well as increases or decreases in expenses.
The formula for ROE is profit divided by shareholders' equity, which is recorded annually on a company's balance sheet. If revenue grows relative to stable expenses and equity, ROE improves. If revenue declines relative to those other factors, so does ROE. Companies generate revenue gains through improved marketing, market expansion, improved product development and product diversification. Globalization is another common way to add new revenue streams. When companies cut business units or products from their portfolio, the net result is often a short-term decline in revenue. This revenue decline also reduces ROE.
Expenses are the other core variable that impacts profit, and therefore ROE. A company's primary operating expenses include costs of goods sold and fixed overhead. If a company negotiates lower costs with its product suppliers, it improves profit and ROE, assuming other factors remain constant. If inflation leads to higher supply costs, ROE falls. Utility expenses and building rent are common overhead expenses, and reductions in those costs improve ROE.
Irregular Profit Activities
Other non-operating activities impact a company's bottom-line profit, and therefore, its ROE. Some companies invest funds to hedge against the risks of loss or to generate additional revenue. Investment gains improve profit and ROE, while investment losses reduce net profit and ROE. The sale of equipment in a given period also boosts revenue, bottom-line profit and ROE. Irregular expenses include legal fees and one-time acquisition costs. Such fees recognized in a given period lower the company's periodic net profit, and subsequently, its ROE.
Financing activities aren't tied to core operations, but they can impact ROE. In particular, when a business issues new stock or buys back existing stock, ROE is affected. Issuing new stock raises the shareholders' equity. Without any correlating impact on revenue, ROE declines with higher equity value. One of the ways a company may immediately boost ROE is buying back stock. A buy back occurs when a company purchases outstanding shares and reduces the value of shareholders' equity. Even though revenue remains constant, ROE grows in this scenario.
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