Return on equity, or ROE, is a profitability ratio that measures the rate of return on resources provided for by a company’s stockholders’ equity. Hence, it is also known as return on stockholders’ equity or ROSHE.
The ROE formula makes use of “net income” obtained from the income statement and “stockholders’ equity” from the balance sheet. It is computed by dividing the net income generated during the period by the average of stockholders’ equity employed in that period.
Net Income ÷ Average SHE
The average of stockholders' equity is preferred over simply the ending balance of SHE. This is because the net income represents activity for a period, while SHE is measured as of a certain date. To fix this mismatch by some means, the average of the beginning and ending balance of stockholders' equity is used.
PQR Company generated a net income of $5.7 million in 2021. The following items have been extracted from the company’s balance sheet (in millions of dollars).
| 2021 | 2020 | ||
| Current assets | 10.5 | 7.5 | |
| Non-current assets | 34.5 | 22.5 | |
| Total assets | 45.0 | 30.0 | |
| Total liabilities | 21.0 | 12.9 | |
| Stockholders' equity | 24.0 | 17.1 | |
| Total liabilities and equity | 45.0 | 30.0 |
| Return on equity | = | Net income |
| Average SHE | ||
| = | 5.7 | |
| (24.0 + 17.1) ÷ 2 | ||
| Return on equity | = | 27.7% |
The return on equity is similar to the “return on assets”. Assets come from two sources: debt and equity. The ROE focuses on the latter. Return on equity measures profitability using resources provided by investors and company earnings.
A high return on assets shows than the business was able to successfully utilize the resources provided by its equity investors and its accumulated profits in generating income. Nonetheless, just like any other financial ratio, the ROE is more useful if it is compared to a benchmark such as the average ROE in the industry where the company operates or the company's ROE in the past years.
Return on equity (ROE)
