Return on Equity = Net Income / Shareholders' Equity
Small business owners, executives, investors, and analysts look to ROE to measure a company’s financial health. ROE is a popular metric to compare companies in the same industry.
All things equal, a higher ROE is better. To increase return on equity, you will need to increase net income or decrease equity.
Another way of calculating a company’s equity value is share capital plus retained earnings less treasury shares.
This company would have accumulated losses for consecutive years, meaning that their losses are greater than any funds received from selling stock.
Companies with negative ROE values cannot be compared to those with positive ROEs.
To calculate return on equity, you need to know net income and total equity for the accounting period. If you are given these two values, you can use this form of the formula:
ROE = Net Income / Total Shareholders’ Equity
If you are given a company’s asset and liability balances, you can calculate shareholders’ equity by using the balance sheet formula.
Return on equity is always displayed as a percentage. Companies will want a higher ROE, which shows that they are able to generate more profit based on the investment into the company.
Increasing net income and reducing total equity will both increase ROE. In the next section, we will walk through several calculations of return on equity.
Now we will go through the calculations for return on equity. The information for fiscal year 2021 and 2022 for Company A is presented below.
Our goal is to calculate ROE and understand the implications (e.g., what are the numbers telling us).
Company A, FY2021
Company A, FY2022
Let’s calculate ROE for 2021:
ROE = $250,000 / $5,000,000
ROE = 0.05
ROE = 5.0%
And now let’s do the same for 2022:
ROE = $300,000 / $10,000,000
ROE = 0.03
ROE = 3.0%
Company A grew revenue by 50% and profit by 20%, which are both very positive. However, ROE declined steeply between the two years.
The reason is that Company A doubled its equity balance, likely by issuing equity to new investors. To fully understand this change in ROE, you would need to understand the company’s overall strategy and its plans to raise future capital, grow revenue, or increase profitability.
As a reminder, you want to match net income to total equity for the given period.
Here are a few other income ratios that are helpful when evaluating a company’s performance.
Profit Margin = Profit / Revenue
There are several types of profit margin analysis, including gross profit margin, operating profit margin, and net profit margin.
Understanding a company’s margin at each step of the income statement is very helpful to uncover the fundamentals of the business.
ROA = Net Income / Total Assets
Similar to ROE, ROA is a measure of company efficiency. A high ROA is better as it shows that management is using assets to generate more profit than a low ROA.
ROA might not be a helpful tool for companies with high intangible assets. An alternative to the standard ROA formula is to divide net income by the fixed assets balance.
ROIC = Net Income / (Total Debt + Total Equity)
Companies are financed by a combination of debt and equity. Looking at ROIC allows you to understand if a company is efficiently utilizing its resources and, if they raise additional capital, if that new money is being used correctly.
ROIC might be a better calculation than ROE for companies that are heavily financed by loans.
The DuPont Analysis, also called the DuPont Model, is a specific type of financial ratio that breaks a company’s performance into three components: profitability, asset utilization, and financial leverage.
The expanded version of the DuPont formula is:
ROE = (Net Income / Sales) x (Sales / Total Assets) x (Total Assets / Common Equity)
We can simplify these values to get the basic DuPont Analysis version:
ROE = Net Profit Margin x Total Asset Turnover x Equity Multiplier
By breaking down the components, you can understand if the positive ROE stems from a high profit margin, great asset utilization, or high amounts of leverage.
Companies with too much leverage might have high levels of risk, and should be approached carefully.
Companies typically have a positive net income and positive shareholders’ equity, which will result in a positive percentage. This makes ROE a useful metric to compare profitable companies to one another and to industry benchmarks.
If a mature public company has a declining ROE year over year, that could be a measure of a poor management team or business strategy.
In more unique circumstances, ROE could be negative. This is due to a company that has a net loss (which would make the numerator negative) or a negative shareholders’ equity (which would make the denominator negative).
Companies could have a negative equity balance if they have sustained losses resulting in a negative retained earnings. Furthermore, ROE can be biased by share buybacks or other large changes to equity.
Return on equity is usually presented in a financial dashboard alongside other measures of profit such as net profit, net profit margin, return on assets, and return on invested capital.
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