Imagine you are in a shareholder in a company what is the first thing you would be interested in? Firstly you would want to know how much Dividend the company will pay you. That will be your Cash Earnings from the Investment you have made in a company. It can also be looked as a pay back of the Investment that you have made in the company.
After having found out about the Dividend the company pays, you would be interested in knowing the profit which the company has made which is available to the shareholder's. The company may use this profit to pay dividend or may retain this profit to grow the company. Most companies would pay a certain percentage of this profit as Dividend and utilize the balance portion for growth of the business. However this money which is utilized by the company belongs to the shareholders and is like a further investment which you have made in the company. The money which is retained by the business is carried forward to the Balance Sheet as Retained Earnings (after making provisions for certain statutory reserves which may be required).
The net income or profit which is available to the shareholder's to the Shareholder's Fund is known as the Return on Equity (ROE). In simple words it states the profit which the company has made from the investments made by the shareholders.
Formula
Return on Equity (ROE) = Net Income / Shareholder's Equity
ROE is also known as Return on Shareholder's Funds or Return on Net Worth. The result from the above formula is expressed as a percentage.
Net Income is the Net Profit which the company has earned during the period. It is the Profit After Tax which is available for distribution to the shareholder's. The Net Income is usually considered after deducting the preferred dividend, since the ROE is mostly calculated on common equity.
Shareholder's Equity includes Share Capital, any reserves which are required to be created and Retained Earnings. It is also known as Net Worth i.e. Total Assets minus Total Liabilities. In case ROE is calculated for common shareholder's preferred equity is deducted which is usually the case. ROE can also be calculated by taking the Average Capital i.e. Opening Capital plus Closing Capital divided by 2.
Example
Profit And Loss Account (Relevant Figures)
Revenue - $ 100,000
Total Costs - $ 90,000
Profit Before Tax - $ 10,000
Tax - $ 2,000
Profit After Tax - $ 8,000
Balance Sheet (Relevant Figures)
Assets
Fixed Assets - $ 75,000
Current Assets - $ 75,000
Total Assets - $ 150,000
Equity
Capital and Reserves
Share Capital - $ 50,000
Retained Earnings - $ 30,000
Liabilities
Long Term Loans - $ 20,000
Current Liabilities - $ 50,000
Total equity and liabilities - $ 150,000
Return on Equity (ROE) = Net Income / Shareholder's Funds
ROE = 8000 / (50,000 + 30,000)
ROE = 10%
Commentary
In the example above ROE is 10% which is reasonable. ROE of some of the best companies usually averages 10% to 20%. ROE of 15% is normally considered to be good for most industries. ROE below 5% requires improvement. If ROE is above 20% it is remarkable, however very difficult to sustain.
Like most ratios it is important to compare ROE calculated with other companies in the same industry.
