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.
|Cost of sales||320,000|
|Income before tax||155,000|
|Income tax expense||41,000|
|Long term assets||450,000||375,000|
|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%.
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.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.