Return on Equity

I’ve wondered how many companies calculate their return on equity. It’s a revealing statistic of just how well the owners’ investment is performing.

What is Return on Equity?

Look at the example below of an imaginary company.

ROE

The formula for calculating return on equity is to divide the net income for the period by the average equity for the period. The average equity is calculated as the average of the equity at the beginning of the period and the equity at the end of the period. So, the formula for return on equity is:

Net Income / ((Equity at Beginning of Period + Equity at End of Period) / 2) and is expressed as a percentage.

In the box on the bottom right of the example is the calculation.

So, in the above the example the calculation is:

ROE = 12,500 / (219,000 + 231,500)/2)

ROE = 12,500 / 225,250

ROE = 5.55%

Why is this Important?

Simply put, the calculation of return on equity is a good indication of just how efficiently the owners’ investment in a business is performing. Is the return sufficient? If it is not, then perhaps the investment would be better utilized elsewhere. But, let’s not jump to that conclusion too easily. There are other things to consider, such as:

  • Salaries paid to owners reduces net income and thus ROE, but they still got it
  • Wages paid to employees are important to them and the economy
  • The company’s products and services may be well liked and needed

Of course there are other contributions made by operating a business, but the ROE is one way to get a quick picture of how efficiently a company is utilizing owners’ investment.

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.

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