Last Updated on April 13, 2022
A return on equity (ROE) ratio measures the probability of a business. To calculate the return on equity, business owners must divide the net income by the shareholder’s equity. Shareholder’s equity is a business’ gross assets minus liabilities. ROE is an essential metric for business owners because it allows you to gauge your profit levels.
How to Calculate Return on Equity Ratio?
Net income is the total income a business receives, minus net expenses and taxes, over a certain period. Usually, the period is quarterly or yearly. Net income doesn’t include preferred shareholder dividends. Although the calculation doesn’t incorporate those dividends, it does include common shareholder dividends.
Business owners can calculate shareholder equity by adding the shareholder’s equity at the beginning of the period in question. The two periods must match each other, or the results won’t be accurate.
Business owners and investors can find these two numbers in financial statements. Business owners can find their net income for the prior year on an income statement, which totals the financial activities of said corporation for that year.
You can find shareholder equity on your balance sheets if you are a business owner. Balance sheets are the complete history of a company’s asset and liability changes.
Once a business owner or investor determines these values, calculating the return on equity ratio is easy. Simply divide the net income amount by the shareholder equity. To find a percentage, multiply the ratio by 100. The formula is as follows:
- ROE Ratio = Net Income / Shareholder Equity
Return on Equity Ratio Example
Let’s go through an example to show how to calculate an ROE ratio. Walmart had a net income in 2021 of $13.51 billion, while they had shareholder equity equal to $80.925 billion. Expressed in an equation, ROE looks like this:
- ROE ratio = 13,510,000,000 / 80,925,000,000
- ROE ratio = 0.167
In terms of a percentage, Walmart’s return on equity would be 16.7%.
In general, it’s hard to compare ROE ratios across industries because such industries have different investments, uses for those investments, debt levels, and income. For example, it would be almost impossible to compare the ROE of Exxon with Walmart because they operate in fundamentally different business settings with differing levels of cost.
But for most industries, economists consider an ROE of 15% or more as healthy. New York University compiled ROE data for all major sectors, determining that the average ROE for U.S. businesses was 15.34%.
Importance of ROE Ratio
A return on equity ratio is essential for business owners because it shows them how well a company’s investments generate profit. An ROE ratio essentially tells business owners how much net income the company received per investment.
An ROE ratio is significant for business owners and investors to understand. Understanding the return on equity ratio allows investors to choose investments that have a better chance of returning profits.
Understanding their ROE ratio can help business owners use investments more efficiently. Since ROE measures the profitability of an investment, it can help a business owner understand what investments are worthwhile and which are not.
ROE looks at a company’s bottom line by utilizing shareholder equity. When a corporation calculates assets, it first deducts liabilities and taxes. By using shareholder equity as a determinant, business owners can calculate a ratio that tells them how much profit each investment generates for the business.
Return on equity is just one metric that business owners and investors can use to understand the company’s financial health. There are two primary reasons ROE isn’t the best tool to use on its own.
First, companies that take on a lot of debt can artificially increase their ROE ratio. When a company takes on a lot of debt, it lowers the value of the denominator in the equation. When this occurs, the ROE ratio increases. It can obscure the actual financial situation of the corporation, causing investors to think the company is in a better position than reality.
When a company posts losses for a few years, it will likely reduce shareholder equity. If this occurs, and then the company has a profitable year, it can create an artificially high ROE. This is due to the depreciating shareholder equity. When shareholder equity decreases, it also causes the denominator to decrease, which will inflate the ROE ratio.
ROE vs. Return on Invested Capital (ROIC)
While ROE only looks at equity to determine profitability, return on invested capital (ROIC) looks at equity and debt. ROIC is sometimes called return on capital (ROC), and businesses often use them interchangeably.
The formula for ROIC is as follows:
- ROIC = Net Income / (Debt + Equity)
The formula is very similar to ROE, but it has the addition of factoring in debt as well. Debt can be anything from outstanding bonds to loans.
ROIC is another vital metric for understanding profitability. It measures the difference between the money a company makes and the costs a company must pay for its debts and equity. ROE only measures the equity side.
ROIC helps business owners understand their financial position in relation to the debt and equity the business holds. It can help investors see whether a company has too much debt and whether that debt has led to profitable business ventures.
ROIC also alleviates the limitations ROE has in terms of factoring in debt. For ROE, a significant amount of debt won’t impact the ratio, but the same debt levels will have a substantial impact on the ROIC.
Return on equity is an essential metric for understanding the health of a business. By understanding the profitability of your own business, you can make better decisions with the investments made in your company.
On the other end, investors can use an ROE ratio to decide whether or not a business is worth investing in. For business owners, it’s essential to understand ROE so that the company can attract more investment.
Grey is the Director of Marketing for altLINE by The Southern Bank. With 10 years’ experience in digital marketing, content creation and small business operations, he helps businesses find the information they need to make informed decisions about invoice factoring and A/R financing.