Background

Gikomba Ltd is considering the financial results for the year ended 31 December 2020. The industry places great reliance on the return on equity (ROE) as an indicator of how well a company uses shareholders funds to generate a profit.

Return on equity (ROE)

Gikomba Ltd analyses ROE in order to understand the fundamental drivers of value creation in the company. ROE is calculated as:

Return on equity = Net profit before tax x Sales x Assets

Sales Assets Equity

Gikomba Ltd uses year-end equity and assets to calculate ROE.

The following information in table 1 relates to Gikomba Ltd for the last two years:

2019 2020

(KShs m) (KShs m)

Net profit before tax 30 38

Sales 200 220

Assets 250 210

Equity at 31 December 175 100

Required:

(a) Discuss the usefulness to investors of the ROE ratio and its component parts provided above and calculate these ratios for the years ended 31 December 2019 and 2020. These calculations should be based upon the information provided in table 1.