Return on Equity

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

In order 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 investment.

Basically the return on equity measures the ability of a business operation to use its money to generate earnings. The ratio 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

  • 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.

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

Income Statement
Cost of sales320,000
Gross margin480,000
Operating expenses200,000
Operating income170,000
Finance costs15,000
Income before tax155,000
Income tax expense41,000
Net income114,000
Balance Sheets
Accounts receivable280,000218,000
Current assets350,000256,000
Long term assets450,000375,000
Total assets800,000631,000
Accounts payable150,000130,000
Other liabilities85,00065,000
Current liabilities235,000195,000
Long-term debt145,000130,000
Total liabilities380,000325,000
Retained earnings270,000156,000
Total equity420,000306,000
Total liabilities and equity800,000631,000

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 case the average historical return on equity to the owners for the year is 30.30%.

In like manner this calculation can be carried out for any business. To demonstrate we can calculate the ROE of Apple using their income statement and balance sheets.

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. Consequently 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.

Additionally 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.

Last modified October 11th, 2022 by Michael Brown

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 degree from Loughborough University.

You May Also Like