The return on equity ratio can be calculated using the following formula:
The ratio of net income (from the income statement) to net worth or stockholders’ equity (from the balance sheet) shows you what you’ve earned on your investment in the business during the accounting period. Bankers often refer to this ratio as ROI — return on investment.
You can compare your business’s return on equity to what you might have earned on the stock market (or even a simple bank account!) during the same period. Over time, your business should be generating at least the same return that you could earn in more passive investments like stocks, bonds, and bank CDs. Otherwise, why are you spending your time, trouble, and capital on it?
A high return on equity may be a result of a high return on assets, extensive use of debt financing, or a combination of the two.
In analyzing both return on equity and return on assets, don’t forget to consider the effects of inflation on the book value of the assets. While your financial statements show all assets at their book value (i.e., original cost minus depreciation), the replacement value of many older assets may be substantially higher than their book value. A business with older assets, generally, should show higher return percentages than a business using newer assets.
If you’re assessing return on equity for a corporation, keep in mind that net income reflects your expenses for any salary paid to yourself or other owner-employees. Since many shareholder-employees of closely held corporations — for tax purposes — draw the highest salaries possible, return actually may be higher than indicated by this ratio. Inventory policy and the policy of the business on the treatment of borderline expense/capital items also can have a significant impact on this ratio.