Return on equity (ROE) is one of the profitability ratios used to measure the efficiency of a company to generate profit for its equity shareholders. This ratio indicates the relationship between net income and shareholder’s fund.
Return on equity is also known as ‘Return on net worth’.
Return on equity is used to compare the efficiency of a firm to generate profit, with other companies in same industry. If a company uses more debt instruments to raise funds, this ratio results in higher value however does not shows the true picture.
Formula for the calculation of return on equity (ROE):
ROE is calculated by dividing the amount of net income by shareholder’s fund. The formula which is used in this calculation is:
Return on equity = Net income / Shareholders’ fund
Net income refers to the amount of money remained after subtracting COGS, operating expenses, interest, taxes and preference shareholder’s dividend (not equity shareholder’s dividend) from total revenue.
Shareholder’s fund refers to equity share capital.
For a better picture, average shareholders’ equity is used instead of total shareholders’ fund. In this case formula is
Return on equity = Net income / Average shareholders’ fund
Average shareholders’ fund is calculated by adding the amount of equity capital at the beginning of financial year and equity capital at the end then the result is divided by 2.
Average shareholders’ fund = (Equity capital at the beginning + equity capital at the end) / 2