In real sense, ordinary shareholders are the real owners of the company. They assume the highest risk in the company. (Preference share holders have a preference over ordinary shareholders in the payment of dividend as well as capital.
Preference share holders get a fixed rate of dividend irrespective of the quantum of profits of the company). The rate of dividends varies with the availability of profits in case of ordinary shares only. Thus ordinary shareholders are more interested in the profitability of a company and the performance of a company should be judged on the basis of return on equity capital of the company. Return on equity capital which is the relationship between profits of a company and its equity, can be calculated as follows:
Formula of return on equity capital or common stock:
Formula of return on equity capital ratio is:
Return on Equity Capital = [(Net profit after tax − Preference dividend) / Equity share capital] × 100
Equity share capital should be the total called-up value of equity shares. As the profit used for the calculations are the final profits available to equity shareholders as dividend, therefore the preference dividend and taxes are deducted in order to arrive at such profits.
Calculate return on equity share capital from the following information:
Equity share capital ($1): $1,000,000; 9% Preference share capital: $500,000; Taxation rate: 50% of net profit; Net profit before tax: $400,000.
Return on Equity Capital (ROEC) ratio = [(400,000 − 200,000 − 45,000) / 1000,000 )× 100]
This ratio is more meaningful to the equity shareholders who are interested to know profits earned by the company and those profits which can be made available to pay dividends to them. Interpretation of the ratio is similar to the interpretation of return on shareholder’s investments and higher the ratio better is.
You may also be interested in other articles from “financial statement analysis” chapter: