Definition of Return on Equity (ROE)
- ROE is another method to measure the profitability of a company.
- The ROE divides the net income of a company with the shareholder’s equity.
- The ROE is expressed as a percentage.
- The shareholder’s equity is the company’s assets minus the company’s debt.
- Therefore the ROE is arguably the net return on assets.
- The ROE, therefore, measures how effectively a company uses its assets to generate profits.
- The ROE’s in each sector are different; therefore, its important to compare with the companies in the industry.
What is the Formula for ROE?
- The ROE can be calculated by dividing the Net Income by the Shareholder’s Equity.
Net Income ÷ Shareholder’s Equity
- The net income can be calculated by subtracting the Revenue by Cost of Goods Sold, Expenses, Depreciation, Amortization, Interest, and Taxes
- The Average Shareholder’s Equity can be calculated by subtracting the Total Assets by the Total Liabilities
ROE in Practice
- Opac Corporation has a revenue of $50,000,000, and its cost of goods sold is worth $35,000,000.
- Furthermore, Opac also spends $2,500,000, on salaries, $300,000 on utilities and $120,000 on maintenance costs.
- The depreciation is $35,000 on the assets that Opac owns. The amortization value is $20,000 and Opac currently pays $5,000,000 in interest. The tax rate is 20%.
- The total assets are worth $150,000,000, and the total liabilities are worth $80,000,000. What is the ROE?
- 50,000,000 – 35,000,000 – 2,500,000 – 300,000 – 120,000 – 20,000 – 5,000,000 = $7,060,000
- 7,060,000 x 0.2 = $1,412,000
- 7,060,000 – 1,412,000 = $5,648,000
- Therefore the Net Income is $5,648,000
- 15,000,000 – 8,000,000 = $7,000,000
- 5,648,000 ÷ 7,000,000 = 0.08
- 0.08 x 100 = 8%
- Therefore the ROE for Opac corporation is 8%