What it means
Return on equity is a favourite measure of shareholders because it links profit to the owners' capital. But profit can be shaped by accounting estimates, timing differences and one-off gains, so careful investors also check it against cash.
Cash return on equity uses cash flow from operating activities as the top line of the ratio. The bottom line is shareholders' equity, which is the book value of what the owners have put in plus retained profits.
Using average equity over the year is the usual approach. It smooths out the effect of share issues, buybacks and dividends that change equity part-way through the period.
Debt plays a big role. A company funded mostly by borrowing has a small equity base, which can push both versions of the return on equity up sharply, so always read the ratio alongside gearing (the share of funding that comes from debt).
A persistent gap between the two ratios is a prompt for questions. If the cash return is far below the ordinary return, profit may be sitting in unpaid invoices or stock; if the cash return is higher, non-cash charges such as depreciation may be depressing reported profit.
A practical use is in target setting. Boards sometimes link management bonuses to a cash-based return measure so that executives are rewarded for turning profit into cash and not just for growing sales.
This also discourages aggressive revenue recognition that cannot be backed by cash collection.
In practice
Real-world examples
Example 1
A private equity investor reviewing a family-owned packaging company finds an ordinary return on equity of 18% but a cash return of only 6%. She asks to see the receivables ledger before going further. She also checks the age of the largest invoices.
Example 2
The finance director of a consulting firm sets a target of a 15% cash return on equity in the annual plan. This tells managers that billing without collecting will not count towards the goal. Sales managers see the new target and start to follow up on overdue accounts. Bonus discussions now refer to cash collected as well as invoices raised.
Example 3
A retired shareholder compares two dividend-paying companies. One has a cash return on equity of 22% and the other 9%, which helps her judge which one is more likely to sustain its dividend. She prefers the higher figure unless the lower one belongs to a business that is investing heavily for growth.
Think of it
Cash return on equity shows how much actual cash each dollar of owners' investment generates.
Formula
Calculation
Cash return on equity = Cash flow from operations / Average shareholders' equity
A services company generates cash flow from operations of $300,000. Shareholders' equity was $1,400,000 at the start of the year and $1,600,000 at the end, so average equity = ($1,400,000 + $1,600,000) / 2 = $1,500,000. Cash return on equity = $300,000 / $1,500,000 = 0.20, or 20%. For every $1 of owners' money invested, the business produced 20 cents of operating cash during the year.Case study
Seen in the real world
Tidewell Marine Services is an illustrative, fictional boat maintenance company owned by three partners. Net income was $210,000 on equity of $1,000,000, which looked like a respectable 21% return.
However, operating cash flow was only $90,000, a cash return on equity of 9%. Most of the shortfall came from long-running repair jobs that had been billed but not paid, and from a growing stock of spare parts.
The partners introduced stage payments on large jobs and cut parts stock by $50,000. In the illustrative next year, operating cash flow rose to $200,000 and the partners were finally able to take larger distributions without borrowing. They also stopped using the overdraft that had been a regular feature of the previous three years. The change was not dramatic, but it taught the partners to treat cash as the final test of whether profit was real. They now review the ratio each quarter alongside their accountant. The accountant prepares the calculation from the standard accounts.
Watch out
Common mistakes
- Treating a high cash return on equity as proof of strength when equity is tiny because of years of losses or heavy buybacks.
- Mixing definitions of cash flow, such as using free cash flow in one year and operating cash flow in another.
- Ignoring leverage, so that a highly indebted company looks better than it really is.
Questions
People also ask
How is this different from return on equity?
Return on equity uses net income, whereas the cash version uses operating cash flow, so it is less affected by accruals and estimates.
Can the ratio be negative?
Yes, if operating cash flow is negative the ratio is negative, which signals the business is consuming cash.
Which is better for valuing a company?
Neither alone is enough, but a large gap between the two is a useful warning sign to investigate.
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