What it means
Return on equity is the shareholders' headline measure: what the business earned on their money. Its accounting form has two well-known weaknesses.
Net income can be managed, and leverage inflates the ratio regardless of operating performance. Cash return on equity addresses the first by substituting cash flow for profit; the second remains and must be read alongside.
The numerator has three common definitions, and the choice should be stated. Operating cash flow gives the broadest measure: cash generated by operations after working capital and tax, before investment and debt repayment.
Free cash flow (operating cash flow less capital expenditure) gives the cash available to all providers of capital after maintaining and growing the assets. Free cash flow to equity (free cash flow less net debt repayment plus net new borrowing, or equivalently less interest and principal paid to lenders) gives the cash that could actually go to shareholders.
The strict version is the most meaningful for owners: it is the rate at which the business can pay them without shrinking or borrowing. The denominator is shareholders' equity, usually averaged over the year.
Equity is affected by accounting policies (revaluations, goodwill, treasury shares) and by buybacks and dividends that reduce it, so a company that has bought back shares heavily shows a high ROE on a shrunken base. Some analysts use tangible equity (excluding goodwill and intangibles) to avoid acquisitions distorting the figure.
Reading the measure: cash ROE close to or above accounting ROE means the shareholders' reported return is real; cash ROE well below means profit is being retained in working capital or capitalised assets rather than becoming distributable cash. Against the cost of equity (the return shareholders require, typically 8% to 12%), a cash ROE above it means the business is creating value in cash terms; below it, the shareholders would do better elsewhere unless the shortfall is investment that will pay later.
Against leverage, a high cash ROE on a highly leveraged balance sheet is a return for risk, and the cash ROA shows the underlying operating productivity without the leverage. For private company owners, free cash flow to equity over equity is the practical measure of what the business yields them: the cash they can take out each year as a percentage of what they have in.
A business with $2 million of equity producing $300,000 of free cash flow to equity yields 15%; if the owners could sell for $2 million and invest at 7%, the business is earning them more than the alternative, before considering risk and their own labour.
In practice
Real-world examples.
Example
A software company reports cash ROE of 35% against accounting ROE of 22% because customer prepayments make cash exceed profit and its equity base is small.
Example
A private manufacturing company's owners calculate FCFE ROE of 14% and decide it justifies keeping the business rather than selling and investing the proceeds at 6%.
Example
A retailer's accounting ROE of 20% is shown to be a cash ROE of 5% because of inventory growth and store investment, and its shares derate.
Think of it
“Cash return on equity shows how much actual cash each dollar of owners' investment generates.
Formula
Calculation
Cash Return on Equity = Operating cash flow / Average shareholders' equity x 100%
Free Cash Flow to Equity ROE = (Operating cash flow minus Capital expenditure minus Net debt repayment) / Average shareholders' equity x 100%
Leverage effect: Cash ROE is approximately Cash ROA x (Total assets / Equity)
Worked example. A regional food manufacturer reports: net income $4,800,000; operating cash flow $7,200,000; capital expenditure $3,000,000 (maintenance $2,200,000); net debt repayment $1,000,000; shareholders' equity $30,000,000 at the start and $33,000,000 at the end (average $31,500,000); total assets averaging $70,000,000.
- Accounting ROE = $4,800,000 / $31,500,000 = 15.2%
- Cash ROE (operating cash flow basis) = $7,200,000 / $31,500,000 = 22.9%
- Free cash flow = $7,200,000 minus $3,000,000 = $4,200,000; FCF ROE = 13.3%
- Free cash flow to equity = $4,200,000 minus $1,000,000 = $3,200,000; FCFE ROE = 10.2%
- Cash ROA = $7,200,000 / $70,000,000 = 10.3%; leverage multiplier = $70,000,000 / $31,500,000 = 2.2; cash ROA x multiplier = 22.9%, reconciling to cash ROE
Reading: the shareholders' accounting return of 15.2% is backed by operating cash of 22.9% of equity, so the profit is converting. After maintaining and growing the assets and repaying debt on schedule, the business could distribute 10.2% of equity, $3,200,000, without borrowing or shrinking. The dividend paid was $2,000,000 (6.3% of equity), so $1,200,000 was retained in cash. Against a cost of equity of 10%, the FCFE return of 10.2% is just at the threshold; the business is creating value modestly in cash terms while investing $800,000 a year in expansion capex that should lift future cash flow.
Comparison: a competitor reports accounting ROE of 18% and cash ROE of 9%. Its profit is higher relative to equity, but half of it is being absorbed by working capital growth and capitalised development. Its FCFE ROE is 2%: it could distribute almost nothing without borrowing. The first company's lower accounting ROE is the better return for shareholders in cash.
Leverage test: if the first company refinanced to double its debt and bought back $15,000,000 of shares, equity would fall to about $16,500,000 and, with interest rising by $900,000, operating cash flow to about $6,500,000: cash ROE would rise to 39%, but cash ROA would be unchanged at about 10% and FCFE, after the higher debt service, would fall. The higher cash ROE would be entirely leverage, and the shareholders' risk would have doubled with it.Case study
Seen in the real world.
A listed engineering group had reported ROE of 18% to 20% for five years and its executives' bonuses were tied to it. An activist investor examined the cash version. Operating cash flow over equity had fallen from 21% to 9% over the period; free cash flow to equity over equity had fallen from 12% to nil.
The gap had three causes: receivables had grown as the group financed customers' purchases through extended terms; development costs had been capitalised at increasing rates; and the group had bought back $200 million of shares, shrinking the equity denominator so that the accounting ROE stayed high while the cash return per dollar of equity collapsed. Dividends had been maintained from borrowing.
The activist's presentation showed the two ratios side by side for five years and asked the board which one the bonuses should track. The board changed the incentive scheme to free cash flow to equity, suspended the buyback, and launched a working capital programme; the following year's accounting ROE fell to 14% and cash ROE rose to 16%, and the share price rose because, as the activist put it, the company had started reporting returns its shareholders could bank.
Watch out
Common mistakes.
- Rewarding management on accounting ROE, which can be raised by capitalising costs, recognising revenue early, or shrinking equity through buybacks, without any increase in cash.
- Reading a high cash ROE without checking leverage. Cash ROA shows the operating return; the difference is debt.
- Using operating cash flow over equity as if it were distributable. Free cash flow to equity, after capex and debt service, is what shareholders could actually receive.
Questions
People also ask.
What is a good cash return on equity?
Above the cost of equity (typically 8% to 12%) on a free cash flow to equity basis, sustained over several years, on a leverage level appropriate to the business.
How does cash ROE differ from dividend yield?
Dividend yield is dividends paid over market value; cash ROE is cash generated over book equity. Cash ROE shows what the business could pay; the dividend shows what it chose to pay.
Why can cash ROE be far above accounting ROE?
Large non-cash charges (depreciation, amortisation of acquired intangibles), customer prepayments and working capital releases raise cash above profit. The gap should be understood; it is not always a sign of strength if under-investment is the cause.
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