Return on Equity – ROE

What is Return on Equity?

The return on equity measures the percentage rate of return the owner of a business gets on their investment. It is calculated by dividing the profit after tax by the owners equity. It is sometimes abbreviated to ROE and also known as the Return on Net Worth.

Formula for Return on Equity

Return on Equity = Net Income / Owners Equity x 100%
  • Net income is shown in the income statement. It is sometimes referred to as Profit after tax.
  • Owners Equity is found in the balance sheet and includes capital injected by the owners and retained earnings which belong to the owners.

How to Calculate the Return on Equity

Income Statement
Revenue 900,000
Cost of sales 430,000
Gross margin 470,000
Operating expenses 220,000
Depreciation 120,000
Operating income 130,000
Finance costs 25,000
Income before tax 105,000
Income tax expense 50,000
Net income 55,000
Balance Sheets
Closing Opening
Cash 60,000 23,000
Accounts receivable 270,000 215,000
Inventory 25,000 18,000
Current assets 355,000 256,000
Long term assets 470,000 450,000
Total assets 825,000 706,000
Accounts payable 140,000 120,000
Other liabilities 75,000 55,000
Current liabilities 215,000 175,000
Long-term debt 155,000 140,000
Total liabilities 370,000 315,000
Capital 160,000 151,000
Retained earnings 295,000 240,000
Total equity 455,000 391,000
Total liabilities and equity 825,000 706,000

In the example above the net income is 55,000 and the owners equity is 825,000. The return on equity is given by using the ROE formula as follows:

Return on Equity = Net Income / Owners Equity
ROE = 55,000 / 825,000 = 6.67%

As a refinement of the above calculation the average of the beginning and ending owners equity could be used to give the return on average equity or ROAE.

ROAE = Net Income / Average Owners Equity
ROAE = 55,000 / ((825,000 + 706,000)/2) = 7.18%

Return on Equity Interpretation

The return on equity is considered to be a fundamental financial ratio for investors. It measures the ability of a business to use its money to generate earnings for the investors and owners.

The business should aim to produce a return on equity which is much higher than that on a ‘safe’ investment such as government securities, to compensate for the additional risk involved.

Useful tips for Using the Return on Equity

  • The return on equity will vary from industry to industry. To make comparisons you need to use a comparable business operating in your sector.
  • The return on equity would normally be in the range of 10% to 15% although is can go higher in the short term for some businesses.
Return on Equity – ROE November 6th, 2016Team

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