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
- Net income is shown in the income statement. It is sometimes referred to as Profit after tax.
- 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
| 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 |
| 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 equity is 825,000. The return on equity is given by using the ROE formula as follows:
ROE = Net Income / Equity ROE = 55,000 / 825,000 = 6.67%
As a refinement of the above calculation the average of the beginning and ending equity could be used to give the return on average equity or ROAE.
ROAE = Net Income / Average Equity ROAE = 55,000 / ((825,000 + 706,000)/2) = 7.18%
ROE 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 ROE
- The ROE will vary from industry to industry. To make comparisons you need to use a comparable business operating in your sector.
- The ROE would normally be in the range of 10% to 15% although is can go higher in the short term for some businesses.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.