Return on Equity

Most startup businesses have the aim to maximize profitability and to produce a return for the owner which is much higher than the return they could get from a less risky investment such as Government Securities.

To make the comparison with other investments a financial ratio known as the return on equity (ROE) is used to measure the percentage rate of return the owner of a business gets on their invested equity.

The return on equity measures the ability of a business operation to use its money to generate earnings. It is calculated by dividing the net income by the owners equity.

How to Calculate the Return on Equity

The return on equity formula is as follows:

Return on equity (ROE) = Net income / Equity
  • Net income is shown in the income statement. It is sometimes referred to as net profit or profit after tax.
  • Owners equity is found in the balance sheet and includes capital injected by the owners and retained earnings which belong to the owners.

In the example income statement and balance sheets below, the net income and equity numbers are highlighted in blue.

Income Statement
Revenue 800,000
Cost of sales 320,000
Gross margin 480,000
Operating expenses 200,000
Depreciation 110,000
Operating income 170,000
Finance costs 15,000
Income before tax 155,000
Income tax expense 41,000
Net income 114,000
Balance Sheets
Closing Opening
Cash 50,000 23,000
Accounts receivable 280,000 218,000
Inventory 20,000 15,000
Current assets 350,000 256,000
Long term assets 450,000 375,000
Total assets 800,000 631,000
Accounts payable 150,000 130,000
Other liabilities 85,000 65,000
Current liabilities 235,000 195,000
Long-term debt 145,000 130,000
Total liabilities 380,000 325,000
Capital 150,000 150,000
Retained earnings 270,000 156,000
Total equity 420,000 306,000
Total liabilities and equity 800,000 631,000

If available, the average of the opening and closing equity should be used in the calculation as this gives a more accurate representation of the amount invested by the owners during the year.

ROE = Net income / Equity x 100%
Net income = 114,000
Equity = (420000 + 306,000) / 2 = 363,000 (Average)
ROE = 114,000 / 363,000 x 100% = 30.30%

In this example, the average historical return on equity to the owners for the year is 30.30%.

This calculation can be carried out for any business. Using the income statement and balance sheets of Apple as an example, we have the following calculation.

ROE = Net income / Equity x 100%
Net income = 37,037
Equity = (123,549 + 118,210) / 2 = 120,880 (Average)
ROE = 37,037 / 120,880 x 100% = 30.64%

ROE and the Financial Projections Template

Investors use the return on equity calculation to compare different businesses in deciding whether to invest or not. If you are seeking funding for your business by way of equity investment, it is likely that you will need to include an estimate of the return on equity an investor can expect to make in your business plan.

The return on equity can be calculated for projected figures, and is included in our financial projections template on the financial ratios page. For simplicity, the return on equity calculation has been based on the closing balance sheet equity for the year.

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