## 2.3. Return on equity (ROE)

Return on equity (ROE) measures how effectively a company employs resources provided by owners (i.e., shareholder’s equity) in generating earnings. In other words, this ratio shows the amount of profit the company earned using shareholder’s equity. This ratio is calculated by dividing net income after taxes by average shareholder’s equity.

Return on equity is considered one of the most important profitability ratios.

Return on Equity (ROE) Formula

Return on equity (ROE) is calculated by dividing net income by average shareholder's equity. To determine the average shareholder’s equity for a period, beginning and ending balances of total shareholder’s equity (see balance sheet) are added and the result is divided by two.

 Return on Equity (ROE) = Net Income (after Taxes) Average Shareholder's Equity

Shareholder’s equity (also called net worth or net assets) is what an entity "owes" to owners. Equity can be called shareholders' equity in a corporation or owner's equity in a sole proprietorship. Equity is the difference between assets and liabilities: Equity = Assets – Liabilities.

Return on Equity (ROE) Example

Back to our example of Friends Company. To determine the return on equity ratio, we will use amounts from the balance sheet (average total shareholder’s equity) and income statement (net income). The ratio at the end of fiscal year 20X9 can be calculated as follows:

 Return on Equity = \$2,700 x 100% = 15.7% (rounded) (\$18,350 + \$15,950) ÷ 2

The return on equity ratio of 0.157 (15.7%) indicates that for every dollar of shareholder’s equity there is 15.7 cents of net income. In other words, during 20X9 Friends Company generated a profit equal to15.7% of its total shareholder’s equity.

Important Notes

The following factors should be considered in analyzing the return on equity ratio:

• Normally, larger companies generate higher returns on equity and smaller companies show low returns on equity. This happens because smaller businesses usually return earnings to owners in the form of salaries, which (along with other expenses) are subtracted from total sales to arrive at net income. Thus, at the end of a period smaller companies can have small or zero profit and, respectively, lower returns on equity even though such companies can be highly profitable.
• When comparing return on equity ratios within the same industry, the effect of debt should also be taken into account. Generally, companies with larger outstanding debt balances (on favorable conditions) will have higher (better) returns on equity. But existence of larger debt balances also increases the risk associated with the company which should also be considered.
Not a member? 