What is Return on Equity?

This is another indicator which measures the business organization’s profitability with respect to the money invested by the shareholders. Due to the impact on the shareholder returns, this ratio is considered as one of the most important financial ratios.

This ratio measures the business organization’s efficiency at generating profits of net assets and shows how well the company is doing with investment money. Return on equity is calculated as fiscal year’s net income divided by the total equity and usually expressed as a percentage. The formula goes as;

Return on equity (ROE) = Net Income / Total Equity

Usually if the ROE is high, the business organization is considered as profitable and many investors will be willing to invest. But ROE does not give you the right picture in some cases. As an example, some industries have a high ROE as they do not require many assets such as software development companies. But some industries such as oil refineries require a huge amount of initial investment and assets even before it starts generating any income. In the latter case, ROE will be very low. So, in these cases, no one can conclude that software companies are better investments than oil refineries.

Return on equity varies between the industries as we saw in the earlier example. Therefore, ROE is commonly used for comparing businesses in the same industry.

If you are interested in making an investment, return on equity is one of the critical measures to look at. One good practice is to calculate the growth on ROE. This is done by taking a period and calculating the ROE at the beginning and the end. If there is a positive growth of ROE, then it is assumed that the earnings have been properly invested in the company and the company is growing.

The standard formula for ROE, DuPont Formula is used by almost all industries for calculating their ROE by breaking down ROE in to three components for making the calculations easy.