Return on Equity (ROE)

This section explains the essential and types of financial ratio based on viewed of researchers and scholars. Next, giving definition of Return on Equity, explaining how assess it and the important of ROE in company with managers, investors and shareholders.

2.1.1 Financial ratio

Financial ratios include five different categories: liquidity, profitability, debt management, asset management and market value ratio (Gibson, 1982) that help to evaluate financial statement. Each type has different functionality to predict and study the financial situation of any company (Altman, 1968).

Liquidity ratio: The indicators in this category are calculated and used to determine capability of particular business for paying the short-term obligation. Current ratio, quick ratio, cash ratio are represented to this kind of ratio.

Profitability ratio: The indicators said the overall profitability of the company, also shows how effectiveness the property was used. Business financial theory has authorized two relative dimensions of profitability which are Return on Assets and Return on Assets. Both are used to diagnose a company's profitability (Stancu, 2007). Profit margin, ROE, ROA are showed profitability ratio.

Debt management ratio: it is said how does the company consider its assets to pay off its debt as well as the capability of the company to pay off its long-term or short-term debt; it is also defined as an ability of the company to settle its all liabilities by available cash includes business risk and financial risk;. Financial risk is the risk related to the financial structure of the company (Nguyen, 2015). This ratio include total debt ratio, times interest earned, cash coverage.

Asset management ratio: extremely meaningful indicators for shareholders and investors to consider whether the company is worth anywhere and allows creditors to predict ability to repay current liabilities and evaluation additional debt or the efficiency of using assets of the enterprises (Brigham, 2010) such as inventory turnover, receivables turnover, total asset turnover.

Market value ratio: which describe the stock price and show what the investor thinks about the company and its prospects in the future like Price - earnings ratio, market - to - book ratio.

In corporate financial reports, the analysis of ratio of profitability is very essential point.

Managers and investors who analyze this ratios can assess the performance of the business, helping to make their invested decisions. Financial ratio is an important and effective tool however when using this ratio, it need to put in historical value of same firms or industries because the ratio is counted from accounting so different principle can make different results and based on business practices and cultures of enterprises’ country (Gibson, 2011). Wild (2009) also said that financial investigation is used to figure out the financial situation and performance of the company, in addition to the indicators used to evaluate the financial performance that its profitability in future. Financial indicators were used by interior and extraneous financial data users for having their economic selection. including investing, and performance evaluation decisions.

Some Western researches such as the studies of Altman (1968); Beaver, McNichols & Rhie (2005); Hossari (2006), Vietnamese studies also use both financial statement ratios and nonfinancial elements to search best ratios and find the reason of business failure. Harahap (2004) stated that financial ratios are collected from the financial reports or posts and comparison all to make this numbers be more meaningful and relevant. Financial indicators give this information related to the measurement of business quality and evaluate to decide whether to invest in support of a company (Zager, 2006). One explanation was given by Nissim

& Penman (2001), the financial ratio is standard level to identify and measure differences in negative or positive financial operations and activities of employees in company. Nweze (2011) defined the analysis of financial statements using ratio analysis as putting two financial indicators together. It's more efficient to choose the right variables predetermined ratio which describes the advantages and disadvantages of the firm's financial situation (Tugas & Cisa, 2012). Managers have a duty to identify and control the decisive factors for the implementation of development, sustainable growth for a company (Kochhar, 1996; Cassar, 2004).

In financial accounting and reporting, it is generally demonstrated that there are assured relationships between the items shown in the accounts of profits and losses, in the annual report

as well as between components in the report. Therefore, the financial ratio is used as a means of expressing relationships in business situation. Ezeamama (2010) battles that indicators are effective tool to interpret the financial statement when correlated to a definitive or norm. Pandey (2010) shows the financial analysis is the process through analyzing the numbers to explore the strengths and weaknesses of the financial company, thereby instituting the relationship between the firms by the establishment correct relationships between items in the balance sheet and the profit and loss account of the company.

2.1.2 Definition of Return on Equity

According to Nguyen (2009), ROE is the indicator measuring the profit achieved on the capital contributed by shareholders, is calculated as follows:

ROE Net Income Shareholders′ Equity

(2.1)

It said that a higher ROE means we could use the excess to fund additional transactions to enhance business operations without the need of owners (shareholders) which invest more capital. It also means the company will have less need to borrow more from outside.

A popular approach to separate ROE into three crucial fundamental is using Du-Pont formula or it is known that the strategic profit model. ROE separated into three parts to make it easier to understand changes in ROE over time.

Figure 2.1 Du-Pont Formula

The Du-Pont maintains the function of a firm’s profitability, asset utilization efficiency and financial leverage to analyze a ROE digit. In addition, Du-Pont model shows interactions between specific financial indicators is the ratio of operating profit and sales to determine profitability on invested capital. The equation also shows the relationship and impact of these factors are indicators of capital efficiency, which can set the appropriate decisions and

efficiently based on different level of impact of each different factors to increase profitability.

If ROE is unsatisfactory by some measure, the Du-Pont identity tells the reason.

ROE is often used to analyze for comparison with the stock in the same industry, and the ratio supported to the decision what shares of company should buy. Return on Equity computes the return to common shareholders (Fraser & Ormiston, 2004). ROE is the best measure ability of company to maximize the profit from each investment contract. The higher ROE firm achieved, the stronger competitiveness of the company are.

2.1.3 Particular importance of Return on Equity

Greater importance is given to ROE because it is commonly used by investors when evaluating stock purchases and assessing the corporate performance (Acheampong, 2000).

When the company only reaches ROE equivalent to bank interest, at a relative level, investors should revisit the profitability of the company, as if the company is only profitable at this level.

No company will get a loan from the bank, since the interest on loans is enough to pay interest on a bank loan. Of course, here he just put the case the company has not yet borrowed the bank.

According to Damodaran (2007), ROE “focuses on just the equity component of the investment. It relates the earnings left over for equity investors after debt services costs have been factored in to the equity invested in the asset”. However, the ROE does not describe the details of how much money will be returned to shareholders, but only indicates the profitability that company create based on shareholders’ equity (Berman et al., 2013). Even so, ROE still become the essential financial indicators that shareholders use so as to assess whether their investments are profitable or not (Dietrich & Wanzenried, 2009).

ROE is often a difference for companies with different age. The newly established companies usually have high ROE by deciding to allocate capital simpler. Long-standing companies, especially companies operating in industries with high capital concentration as communications, technology so the ROE are lower, because they are costly to create a contract revenue or profit. On the other hand, the ROE of the industry also is very different, so ROE should compare between similar businesses (in terms of size, product structure ...) or compared with the sector average. Likewise ROE is used as a measure of manager’s performance and define a manager´s remuneration, this can encourage them to invest more projects, which have higher than expected ROE, though those projects can be very risky for companies (Gadoiu, 2014).

2.1.4 Limitation of ROE

Assessing and measuring corporate financial performance is one of the most controversial and discussed issues in financial management. The use of tools to assess the financial performance of enterprises is important.

There are a lot of measures to measure corporate financial performance, but the most commonly used indicators in the studies can be divided into two main groups: first, using multiple accounting tools. Used in previous research, is the ratio between the results achieved (net income, net profit) and inputs (assets, capital, investment capital, equity Property). The second set of indicators, including market-based models. For the first set of indicators: To measure corporate financial performance, ROA and ROE are currently the two most widely used factors.

However, the value of these two factors may depend on how the "profit" indicator is derived. Profit before tax and interest (EBIT) are chosen by many researchers to account for these two factors (Hu & Izumida, 2008, Le & Buck, 2011, Wang & Xiao, 2011). Net profit plus interest (before or after tax) (Shah, Butt & Saeed, 2011; Thomsen & Pedersen, 2000), or simply net profit (LI, Sun & Zou, 2009). Meanwhile, the study said that the use of profit before tax, interest, wear and depreciation (EBITDA).

In summary, the group of factors based on book value is a view of the past or the short-term profitability of a firm (Hu & Izumida, 2008). Because factors such as ROA and ROE are effective indicators for current business results and reflect the value of profits earned in the past accounting periods. In addition, the norms of the first group do not provide a long-term perspective for shareholders and business leaders as they are historical and short-term measures (Jenkins, Ambrosini & Collier, 2011). Therefore, if having decision to purchase stock, it should be further examined other factors besides ROE like ROA, EPS,… In this study, the author conducted research on the impacts of determinants affecting to ROE of business cooperation.