Discuss how the rate of return on common shareholders' equity is calculated

Answer 1

RATE OF RETURN ON COMMON SHAREHOLDERS' EQUITY

The rate of return on common shareholders' equity (ROCE) measures a firm's performance in using and financing assets to generate earnings. Unlike ROA, the rate of return on shareholders' equity considers financing costs. Thus, this measure of profitability incorporates the results of operating, investing, and financing decisions. The calculation of ROCE is as follows:

Rate of Return Net Income -Dividends on Preferred Stock
on Common = ---------------------------------------------------
Shareholders' Equity Average Common Shareholders' Equity

The Numerator

To calculate the amount of net income assignable to common shareholders' equity, the analyst subtracts all amounts required to compensate other providers of financing for the use of their funds. Expenses subtracted in computing net income already include amounts for interest expense, so the calculation of the numerator requires no further adjustment for interest. Because expenses exclude all dividends, the analyst must subtract from net income any earnings allocable to preferred stock equity, usually the dividends on preferred stock declared during the period, to measure the returns solely to the common shareholders. The analyst should not subtract dividends on common stock, because such dividends represent distributions to common shareholders of a portion of the returns generated for them during the period.

The Denominator

The capital provided by common shareholders during the period equals the average par value of common stock, capital contributed in excess of par value on common stock, retained earnings, and any other common shareholders' equity accounts for the period. (Alternatively, subtract average preferred shareholders' equity from average total shareholders' equity.)