# Return on equity

Checked for updates, April 2022. Accountingverse.com

## What is Return on Equity?

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.

## Return on Equity Formula

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.

## Example

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%

## Interpreting the Return on Equity

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.

Key Takeaways

Return on equity (ROE)

• a measure of a company's ability to generate profit, calculated as: net income divided by average total equity
• total equity comprises capital contributions, reserves, and retained earnings (a.k.a. accumulated profits)
• generally, the higher the ROE, the better; but should be compared to a benchmark to provide better insights
Like and share!