- Return on Net Worth (RONW) is used in finance as a measure of a company’s profitability.
- It reveals how much profit a company generates with the money that the equity shareholders have invested. Therefore, it is also called ‘Return on Equity’ (ROE).
- This ratio is useful for comparing the profitability of a company to that of other firms in the same industry.
Return on Net Worth (RONW) Formula
RONW = Net Income / Shareholder’s equity X 100
- The numerator is equal to a fiscal year’s net income (after payment of preference share dividends but before payment of equity share dividends).
- The denominator excludes preference shares and considers only the equity shareholding.
Example…
- A company’s net income for the year was Rs.1,20,000/- and shareholder equity for the year was Rs. 6,00,000/-.
- This gives us a Return on Net Worth of 20% (Rs.60,000/- net income / Rs.3,00,000/- shareholder equity).
- This means that for each rupee invested by shareholders, 20% was returned in the form of earnings.
- So, RONW measures how much return the company management can generate for its equity shareholders.
Therefore…
- RONW is a measure for judging the returns that a shareholder’s gets on his investment.
- As a shareholder, equity represents your money and so it makes good sense to know how well management is doing with it.
- Let us now try to understand how RONW is a more appropriate tool for decision making than ROCE. Difference between Return on Capital Employed (ROCE) and Return on Net Worth (RONW).
Example of ROCE…
- A and B both started a business by investing initial capital of Rs.20,000/- each.
- After one year, A had an after-tax profit of Rs. 8,000 while B made only Rs.6,000/-.
- The return on capital employed for A was 40% (Rs.8,000/- / Rs.20,000/-) while for B it was 30% (Rs.6,000/- / Rs.20,000/-).
- On the face of it, it appears that A was the better manager since he earned more profit and therefore a higher return than B – though both started their businesses with the same amount of initial capital.
So, therefore as an investor you are likely to feel encouraged to invest in A rather than B
But, RONW says…
- Now, assume that A’s business had shareholder equity of Rs.90,000/- and net income of Rs.8,000/-.
- While B’s business had shareholder equity of Rs.60,000/- and net income of Rs.6,000/-.
- RONW of A is Rs. 8,000 / Rs. 90,000 = 8.88%
- RONW of B is Rs. 6,000 / Rs. 60,000 = 10%
- Now, with this measure of RONW, we find that B has done better than A!
To sum it up…
- ROCE considers total capital which is in the form of both equity and long term debt such as loans and borrowings.
- While RONW considers only equity shareholding as the base for deciding efficiency of a company’s operations.
- So, for an equity investor, RONW is a better measure of efficiency than ROCE, since he is interested in knowing the return on his equity investment rather than return on the company’s total capital.
So….
- ROCE is an appropriate measure to get an idea of the overall profitability of the company\’s operations.
While
- RONW is an appropriate measure for judging the returns that a shareholder gets on his investment. Hence successful investors like Warren Buffet assign more importance to a company’s RONW to understand their investment growth potential.