Return on equity (ROE)

Return on equity (ROE) is a profitability ratio that examines financial performance of a company by dividing net income by shareholders’ equity. Simply put, the return on equity ratio gives an idea as to how much profit each dollar of common stockholders’ equity brings in.

ROE can be considered as a tool which helps to examine that how effectively a company is utilising the equity fun financing to complete the operations and fulfill the organisational objectives.

Formula to calulate Return on Equity (ROE)

Return on Equity is calculated by applying the following forumula:

Return on Equity Ratio = Net Income/Shareholder’s Equity

Majority of the time, ROE is calculated just for the common shareholders. In this case, preferred dividends are not considered to be a part of the calculation because these profits are not available to common stockholders. Preferred dividends are deducted from the net income for the the accurate calculation.

Application of Return on Equity (ROE) Ratio

A high return on equity ratio is a good news for investors because this shows that the company is utilising its investor’s funds effeciently. Higher ratios are mostly considered better than lower ratios, but they have to be put under comparison with the other companies’ ratios operating within the industry. Since every industry has different levels of investors and income, ROE can’t be used to compare companies outside of their industries very effectively.