What is Return on Equity?

Return on Equity Definition:

“Tests the financial return the owners of a business are earning, relative to their investment.”

Return on Equity Formula:

The first basic analysis to be performed on the balance sheet involves assessing return on equity (ROE). Return on equity is a measure of what the owners are getting out of the business relative to the amount they invested. Although there are various ways to calculate ROE, we will examine the most common method:

Return on Equity Formula

First, we calculate average stockholders’ equity by adding opening stockholders’ equity and closing stockholders’ equity and then dividing the result by two. Second, net income is the numerator for the ratio, which means that the last figure on the income statement serves as the basis from which we start measuring balance sheet performance. That is, net income serves as our link to the balance sheet at this stage of our financial analysis. Third, the above formula assumes there is no preferred stock equity included in stockholders’ equity. Where such equity exists, the formula would be as follows:

Return on Equity formula with preferred dividend

Return on Equity Example:

Let’s assume Cobalt Company made net income of $5 million last year. If Cobalt’s shareholders’ equity was $10 million at that time, then Cobalt’s ROE can be calculated as:

ROE = $5,000,000/$10,000,000 = 50%

This means that Cobalt earned $0.50 of profit for every $1 equity last year.

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