Demystifying return on equity (ROE) and its significance

Making profits is one thing; keeping your investors smiling is another. That's where return on equity (ROE) comes in. This metric is the real litmus test—it shows whether your profits are translating to shareholder payouts or getting siphoned off elsewhere.

Return on equity reveals how well a company turns equity into profit. It exposes whether a business is an equity-squandering dud or a cash-minting machine. Thanks to this powerful performance indicator, stakeholders can make confident decisions about reinvesting, selling, or changing their investment strategies with clear numbers in hand. 

In this guide, we'll cover what return on equity is all about, the formula to calculate ROE, and how to interpret the results. We'll also compare ROE with ROI and give you some practical examples.

What is return on equity (ROE)?

Return on equity, or ROE, is a crucial metric for measuring a company's financial health. It cuts through all the noise to show one crucial thing — the profit a business generates for every dollar invested by shareholders.

‍A high equity return means the company you're invested in is doing great, squeezing maximum profits from the funds you've put in. For instance, a stellar 15-20% ROE signals an extremely efficient operation. A low return? That's a red flag suggesting that your equity could be better deployed elsewhere to earn a higher return.

That said, the return on equity can vary significantly depending on the industry. Capital-intensive sectors like manufacturing tend to have lower ROEs compared to asset-light businesses like tech. Hence, it's crucial to compare a company's equity return to its direct competitors for an apples-to-apples assessment.

Main components of return on equity

ROE puts two key numbers to work: 

• Net income: This is the business's bottom-line profit after all expenses, such as operations, interest, taxes, etc., have been deducted from revenues. It represents the "leftover" earnings for the business and its shareholders.
  
  
• Shareholder equity: This is the total amount of money that shareholders have invested in the business, obtained by subtracting total liabilities from total assets on the balance sheet. It includes the original investments plus any retained earnings that were reinvested into the business.

Return on equity evaluates performance by relating net income with shareholder equity — measuring how much return will be delivered on the shareholder investment. Therefore, a business with high net income but relatively low shareholders' equity will have a high ROE, as it is effectively generating greater profits in proportion to the equity stake. 

Conversely, a business with more modest profits but a higher equity base will see a lower equity return percentage. This relationship between earnings and the equity funding used to generate them is at the core of the ROE calculation (which we'll explore in later sections).

The importance of return on equity

Return on equity is one of the most significant profitability ratios because it directly ties bottom-line performance to shareholder value creation. Monitoring and benchmarking this vital metric allows stakeholders to assess how well a company is deploying its equity capital.

Here’s why it’s so important:

It measures profitability and efficiency

It provides insight into how efficiently a company generates profits from the money shareholders have invested. A high value indicates the business is adept at utilizing equity financing to generate healthy profits and returns for its investors.

It allows for performance benchmarking

It makes it easy to compare companies' profitability against each other and industry benchmarks. This allows investors to identify underperforming companies that may be mismanaging capital.

It signals effective management

A rising equity return over time means that management is effectively reinvesting retained earnings into productive investments and growth opportunities. In contrast, declining equity returns indicate inefficient capital allocation.

It influences investment decisions

Investors use it to make informed decisions about buying, holding, or selling stock. A high return on equity may attract investors looking for efficient and profitable companies, while a low figure might deter them.

The takeaway? Return on equity provides deep insights into a company's profitability, management efficiency, and financial health. It helps investors and business owners to make informed decisions, compare companies effectively, and assess the long-term potential and sustainability of their investments.

Just like ROE, cash ratio is another critical metric for measuring a company’s liquidity. Learn more about it in our guide: What is Cash Ratio?

Limitations of return on equity

There’s no denying that return on equity is a helpful metric, but it has limitations that you should be aware of to avoid misinterpretations. This includes:

Influence of debt

High levels of debt can artificially inflate this metric. When a company takes on debt, its equity base shrinks, making its equity returns appear higher than they would be if the company were less leveraged.

Focus on historical performance

It's a backward-looking metric that tells you about a company's past profitability relative to shareholder equity. It doesn't necessarily predict future performance.

Impact of non-recurring items

One-time gains or losses, such as the sale of an asset or a legal settlement, can significantly affect net income and, consequently, ROE. These items do not reflect the company's ongoing operational performance.

Disregards company size

It doesn't account for the size of a company. For example, a small company might have a high equity return due to its size and scale, while a larger company with a lower equity return might still be more profitable in absolute terms.

Short-term perspective

It focuses on profitability in relation to equity over a specific period, typically a year. This can encourage short-term thinking and overlook long-term growth and sustainability.

Therefore, you must use ROE in conjunction with other financial metrics like debt-to-equity ratio, profit margin, earnings per share (EPS), and price-to-earnings (P/E) ratio. This will help you to gain a more complete picture of a company's profitability and efficiency.

What is a good return on equity ratio?

A good return on equity ratio depends on the industry a company operates. There's no fixed number, but a range of 15% to 20% is typically considered strong across many industries. It indicates the company is effectively using its equity to generate profits and is likely outperforming many of its peers.

Anything between 10% and 15% is still a solid ROE, showing that the business is generating decent returns on equity. It's a healthy sign, though not exceptional. However, anything below 10% is most likely a red flag—it suggests that the company is struggling to use its equity efficiently or that there are underlying issues affecting profitability. 

Then again, this isn't always a cause for concern if the company is in a capital-intensive industry where lower equity returns are common. For instance, a tech company with a 12% ROE might be underperforming, while a manufacturing firm with the same value could be doing exceptionally well.

Cash flow problems impact business efficiency and profitability. Stay afloat with our in-depth guide on alternative financing options.

How to calculate return on equity (ROE)

You can calculate return on equity by dividing net income over shareholders' equity, then multiplying the decimal result by 100. This will give you a percentage that shows exactly how much profit the equity investment is generating for every $1 invested.

The standard formula is:

Return on equity = (Net Income / Shareholder's Equity) * 100

However, it's quite common to use "average shareholders' equity" for a more accurate calculation because shareholder equity can fluctuate throughout the year. As such, it's fine to use:

ROE = (Net Income / Average Shareholders' Equity) * 100

Here’s an example of ROE calculation to help you understand how it works: 

Imagine a company has the following financial information:

• Financial period: April 2023 - March 2024
• Net Income: $100,000
• Total assets: $500,000
• Total liabilities: $100,000

To figure out the equity returns based on this information, you’ll need to follow a standard process:

Step 1: Calculate shareholders' equity

If you have financial statements for multiple periods (quarters or years), it's more accurate to use the average shareholders' equity. You can calculate this by averaging the shareholders' equity at the beginning and end of the period you're analyzing. However, in this case, we can use the shareholders' equity from a single balance sheet.

Note: Because the company’s financial information doesn’t directly disclose the shareholders’ equity, you’ll need to begin by calculating it. Use this formula:

Shareholders' Equity = Total assets - Total Liabilities

=$500,000 - $100,000

= $400,000

Step 2: Calculate ROE

Since we only have information for one period, we'll use the shareholders' equity we just calculated ($400,000) as the average shareholders' equity.

ROE = $100,000 / $400,000 =0.25

Step 3: Express as percentage

Finally, multiply the decimal value with 100 to express it as a percentage.

ROE = 0.25 * 100 = 25%

This means for every $1 of shareholder investment, the company generated 25 cents in profit or a 25% return on equity — a profitable number indicating that this company is making efficient use of the equity.

Let’s consider another example, this one with a bit more details. Imagine a company has the following financial information split in 6-month periods:

• Financial period: April 2023 - June 2023 (P1)
• Net Income: $8,000
• Total assets: $90,000
• Total liabilities: $50,000

• Financial period: July 2023 - September 2023 (P2)
• Net Income: $12,000
• Total assets: $110,000
• Total liabilities: $70,000

In this case, you'll need to start by calculating the average shareholders' equity. This can be done using the formula:

Shareholders' Equity = Total assets - Total Liabilities

As for the example we’re using, the shareholders' equity for P1 and P2 are $40,000 and $40,000 respectively. With this in hand, we can now figure out the average shareholders' equity using the formula: 

Average shareholders' equity =(P1 + P2) / 2 

Based on this, the average shareholders' equity will be $40,000. Similarly, we can add the net income for both periods to derive a total income of $20,000. Next, let's use the formula we mentioned earlier ROE = (Net Income / Average Shareholders' Equity) * 100. This translates to ($20,000 / $40,000) * 100 = 50%. 

What does this mean? For every dollar of shareholders' equity, the company generated 50 cents in profit over the two quarters. This high value indicates efficient use of equity and strong profitability.

Our tip: ROE is a valuable tool, but it shouldn't be the only factor used to judge a company's financial health. Use it in conjunction with other metrics and industry comparisons for a more comprehensive analysis.

What is the difference between ROI and ROE?

ROI (return on investment) focuses on the profitability of a specific investment. It measures the gain or loss on the investment compared to the initial cost. In contrast, ROE (return on equity) is more specialized — it measures the return generated from the total shareholder equity invested in a company.

The key difference? ROE takes a broader view in evaluating the company's profitability as a whole from the perspective of shareholders and equity holders. ROI, on the other hand, can be applied to individual projects, marketing campaigns, equipment purchases, or any other investments. It uses a straightforward formula: 

ROI = (Net profit from investment / Cost of investment) *100

For example, if you invested $10,000 in a marketing campaign for your business and it generated $15,000, the net profit is $5,000 ($15,000 - $10,000). So, the return on investment (ROI) is ($5,000 / $10,000) * 100 = 50%.

Is lackluster ROE dragging you down? We can help.

As a business owner, you've poured your equity into making your company a success. But are you earning the towering returns your investment deserves?

If your return on equity is looking underwhelming, it may be time to rethink your growth strategy — and your financing. With the right capital at your fingertips, you can supercharge operations, drive efficiency, and send your profitability soaring.

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With revenue-based financing, you can reinvest upfront cash from future earnings without diluting your equity or piling on debt. Likewise, invoice financing enables you to turn your outstanding invoices into an asset, providing an instant cash injection to power growth.

‍Don't let a lack of growth capital drag down your ROE. Step up your financing game with Stenn and unleash the untapped potential hiding in your balance sheet. Apply now—it's quick and easy.