Why does RoE keep falling even though PAT is rising?

By Research Desk
about 7 months ago
1

Return on Equity is the ratio of net income to equity or net assets (i.e. assets - liabilities).

            Return on Equity = Net Income / (Total Assets - Total Liabilities)

If the denominator (assets) rises at a higher rate than the numerator (PAT), RoE will fall, despite rise in profits.

If a company having rising profits and debts starts to reduce its high debt burden by paying off the debt at a fast pace, the Liabilities of the company will start reducing and this will be mostly by the excess cash profits generated by the rising PAT levels. This indicates that the assets may still remain high and the denominator in turn will increase. This situation will result in falling RoE even when the PAT levels keep rising.

Let’s take an example of a company ABC Ltd.

Amt. in Rupees

FY 2018

FY 2019

PAT (a)

20,00,000

30,00,000

Total Assets (b)

5,00,00,000

6,00,00,000

Total Liabilities (c)

3,00,00,000

2,75,00,000

Shareholder’s Capital (d) = (b) - (c)

2,00,00,000

3,25,00,000

Return on Equity (a) / (d)

10%

9.2%

In the above example the RoE has fallen despite the PAT rising because of the lower liabilities and higher assets in the Balance Sheet. Thus, while analysing the company’s RoE an investor should keep a watch on the assets and liabilities of the company to understand the accurate reason for change.

 

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