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Return on Equity
Why use ratios?
It has been said that you must measure what you expect to manage and accomplish. Without
measurement, you have no reference to work with and thus, you tend to operate in the dark.
One way of establishing references and managing the financial affairs of an organization is to
use ratios. Ratios are simply relationships between two financial balances or financial
calculations. These relationships establish our references so we can understand how well we
are performing financially. Ratios also extend our traditional way of measuring financial
performance; i.e. relying on financial statements. By applying ratios to a set of financial
statements, we can better understand financial performance.
Calculating Return on Equity
For publicly traded companies, the relationship of earnings to equity or Return on Equity is of
prime importance since management must provide a return for the money invested by
shareholders. Return on Equity is a measure of how well management has used the capital
invested by shareholders. Return on Equity tells us the percent returned for each dollar (or
other monetary unit) invested by shareholders. Return on Equity is calculated by dividing Net
Income by Average Shareholders Equity (including Retained Earnings).
EXAMPLE — Net Income for the year was $ 60,000, total shareholder
equity at the beginning of the year was $ 315,000 and ending shareholder
equity for the year was $ 285,000. Return on Equity is calculated by dividing
$ 60,000 by $ 300,000 (average shareholders equity which is $ 315,000 + $
285,000 / 2). This gives us a Return on Equity of 20%. For each dollar
invested by shareholders, 20% was returned in the form of earnings.
SUMMARY — Return on Equity is one of the most widely used ratios for
publicly traded companies. It measures how much return management was
able to generate for the shareholders. The formula for calculating Return on
Equity is:
Net Income / Average Shareholders...