What Is the Return on Equity Ratio?

Business people reviewing data in meeting
••• Hero Images / GettyImages

The return on equity ratio, sometimes called return on net worth, is the most important of all the profitability ratio for business owners.

The return on equity allows business owners to see how effectively the money they invested in their firm is being used. It is essentially a measure of how business owners have fared with regard to their investment in the firm. Return on equity is usually seen as the bottom-line measure of a firm's performance.

What Is Equity?

Equity is the ownership interest of investors in a business firm. Investors can own equity shares in a firm in the form of common stock or preferred stock. Equity ownership in the firm means that the original business owner no longer owns 100% of the firm, but shares ownership with others.

On a company's balance sheet, equity is represented by the following accounts: common stock, preferred stock, paid-in capital, and retained earnings. Equity can be calculated by subtracting total liabilities from total assets.

What Is Equity Capital?

Financing a small business with equity means selling part of the company, or issuing shares of stock, to other people, usually known as investors. The small business receives money to finance its operations in return. The investors expect to receive a return on their investment in return.

After equity is sold in the company, the business owner no longer owns 100% of the company. Investors own shares of stock and also own some percentage of the company.

Profitability Ratios

The two types of profitability ratios are margin ratios and return ratios. Margin ratios represent the firm's ability to translate sales dollars into profits. Return ratios measure the overall ability of the firm to generate shareholder wealth.

How Is Return on Equity Measured?

Here's the formula for the Return on Equity Ratio

Net Income/Total Shareholders Equity* = _____%

Total Shareholder's Equity includes the sum of Retained Earnings, Paid-in Capital, Common Stock, and Preferred Stock.

As an example, if the return on equity is 15%, that means, in an accounting sense, that the company generated 15 cents in profit for every dollar in equity.

The return on equity ratio can also be calculated using the DuPont Method.

The DuPont Method

This model incorporates three elements for calculating the Return on Equity. They are:

  • Asset Turnover
  • The Net Profit Margin
  • The Equity Multiplier

The Dupont method allows business owners to pinpoint the source of a company's Return on Equity and make a comparison to their competitors. By using the DuPont method for return on equity breakdown, a business owner can see a company's return on shareholder equity in relation to pertinent profit margins. 

Return on Assets (ROA)

In addition to learning the return on Equity, business owners often want to learn how efficient a business is at turning assets into profits? It is the purpose of the return on assets (ROA) calculation. Return on assets is generally stated in percentage terms, and higher is better, all else equal.

Return on Assets = (Net Income + Aftertax Interest Expense) / (Average Total Assets)