Return on Equity (ROE)
ROE measures a company's profit. It reveals how much net income is created for every dollar of capital invested in a company. For business owners and investors, return on equity (ROE) is critical to understanding financial performance and value creation.
Why is the return on equity important?
Return on equity is a crucial measure of financial performance because it directly correlates to a business generating income and growth it's ability to reinvest earnings and fund growth without additional capital. It reflects the efficiency with which a business is using funds to grow profits. For small businesses, a strong ROE signifies a thriving company that can attract investors, secure loans, and reassure stakeholders of its company's financial health and robustness.
How do I calculate return on equity?
The formula for calculating return on equity is a simple calculation:
Return on equity = net income / shareholder's equity
- Net income is the profit after taxes and all expenses have been deducted from revenues.
- Shareholder's equity refers to the assets remaining after all liabilities are settled. Essentially, it’s what the shareholders own outright.
Return on equity gives us a percentage that indicates how many dollars of profit are generated for each dollar of shareholder’s equity. The higher the percentage, the more efficiently the shareholders' capital is being used. A low return on equity means that a company is not earning much compared to the shareholder equity. It's a warning signal for further investigation before considering debt financing. Negative ROE means that there was a net loss or negative net income; however, this can be due to accounting, so it's possible to have a negative net income and positive cash flow.
Return on equity in 3 steps
Here's more detail on the ROE calculation:
- Find your net income: Your annual net income should be on your income statement. It’s what you have earned after all expenses are paid.
- Determine shareholders' equity: Look at your balance sheet. Subtract total liabilities from total assets to calculate shareholders' equity.
- Divide net income by shareholders' equity: Taking your net income and dividing it by shareholder's equity will give you your ROE.
An example:
Imagine your small business has a net income of $12,000. The equity, as reported on your company's balance sheet, stands at $30,000. Your ROE would be:
ROE = $12,000 / $30,000 = 0.4 or 40%
This positive ROE of 40% means that for every dollar of equity, your business is generating 40 cents in profit.
Another way to break down ROE is called the DuPont formula
ROE = net income/sales x sales/total assets x total assets/shareholder equity
Net profit margin is net income divided by sales.
Asset turnover is sales divided by total assets.
Financial leverage is total assets divided by shareholder equity.
If a company increases any of these three ratios, ROE will also increase. When comparing the ROE of companies, it's important to consider that they may have the same ROE, but different ways of reaching that number.
A key success metric
Return on equity is a key metric for evaluating the health and potential of your business. By routinely measuring and understanding ROE, you can take the pulse of your company, taking action where needed to improve your business's finances. A strong ROE paves the way for sustainable growth and success.
FAQs
What is a good return on equity ratio?
A "good" ROE varies by industry and over time, but generally, an ROE that is higher than the industry average could be considered good. It indicates that your business is more efficient than its peers at converting equity into profit.
What's the significance of shareholders' equity?
Shareholders' equity is equal to how much the shareholders can claim after a company's debts are paid.
Is it possible for return on equity to be too high?
Surprisingly, yes. An extremely high ROE could be due to a high level of debt compared to equity, which might be risky. Or, it could mean the the company's management is not reinvesting enough in itself to ensure future growth.
How can a small business owner improve ROE?
You can improve your company's ROE either by increasing net income, reducing debt, or optimizing your asset base. Strategies include improving operational efficiency, exploring new markets, or revisiting investment strategies.
How can LegalZoom help me with return on equity?
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