As a business owner, there is a broad range of profitability metrics you may wish to explore, including net profit margin and contribution margin. However, one of the most useful profitability metrics in your arsenal is return on equity (ROE). But what is return on equity? Learn more about how to calculate return on equity with our comprehensive guide.
Return on equity explained
Return on equity is a measure of your company’s net income divided by shareholder equity, expressed as a percentage. In other words, it reveals how much net (after-tax) income you’ve earned in comparison to shareholder equity. This is a great way to measure the efficiency with which your business is able to use assets to create profits.
How to calculate return on equity
The basic return on equity formula is as follows:
Return on Equity = Net Income (Annual) / Shareholder Equity
In this return on equity formula, net income refers to your company’s bottom-line profit (before dividends are paid to common shareholders), as reported in your income statement. You can calculate your shareholder equity by subtracting liabilities from assets.
Why is the return on equity formula important?
Return on equity provides you with an insight into your business’s profitability for owners and investors. In short, it helps investors understand whether they’re getting a good return on their money, while it’s also a great way to evaluate how efficiently your company can utilise the firm’s equity. Moreover, the return on equity formula can be used to estimate sustainable growth rates for your business.
What is a “good” return on equity?
To determine whether your company has a good return on equity, you’ll need to compare it with industry benchmarks, as well as similar companies within your industry. In the utility sector, companies tend to have a significant amount of assets and debt on their balance sheet, so a return on equity of around 10% is typical. By contrast, technology firms are likely to have a much higher return on equity, sitting somewhere around 18%.
Although high return on equity ratios are almost always better, in some cases, a high return on equity can indicate potential issues with the business’s financial health. For example, it could indicate that your business has an excessive level of debt due to overly aggressive borrowing. Inconsistent profits could also cause extremely high ROE. Generally speaking, it’s a good idea to aim for a return on equity ratio that’s slightly higher than the industry average.
Limitations of the return on equity ratio
There are several drawbacks associated with the return on equity formula. Firstly, the equation only works if your business has positive figures for net income and shareholder equity. If these numbers are negative (i.e., as a result of making a net loss), then you won’t be able to use return on equity to analyse your company or compare your business with your competitors.
It’s also important to note that there are some variations in the composition of the return on equity formula. In some cases, net income may be replaced with EBIT or EBITDA. Furthermore, some return on equity ratios include intangible assets with shareholder equity, while others exclude it. These variations make it more challenging to use return on equity to compare your business with other firms.
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