What is return on equity?

Definition

Return on equity is net income divided by owner equity. On the books, this is a rate of leftover profit against the owners' residual claim, not a ledger account you debit.

People often shorten the name to ROE after the full name. The percent asks what leftover the owners' stake produced, not what leftover the full asset base produced.

It is not a Balance Sheet line. The books already hold leftover profit and equity; this reading restates them as a percent.

Stay with leftover profit against equity when you read it. Leftover against total assets is a different page.

Where it shows up

P&L: Related to net income.

Balance Sheet: Related to owner equity.

Cash flow: Related to whether that return showed up as cash.

See also: Net Income · Equity · Book Value

When you look at your Income Statement, take net income, the bottom leftover after every expense. Then divide by average equity from the Balance Sheet, usually the start-of-period and end-of-period totals added and halved.

When the percent is high, the owners' stake produced more leftover profit. When it is low, a large equity base produced little leftover.

The Balance Sheet holds the denominator. Book value is that equity figure as the books carry it, not a market price for the company.

On the Statement of Cash Flows, leftover profit and cash from operations can diverge. This page stays on the earnings rate, which can look healthy while wholesale beans sit uncollected.

Retained earnings is usually the largest piece of equity for a shop that has kept its profits. New capital and owner draws also move the denominator from year to year.

How it works

Start with net income for the period. That leftover already subtracted operating costs, interest expense, and taxes.

Divide by average equity for the same window. Using only the year-end total can distort the rate if the owners put in a large capital contribution in December.

$40,000 of net income against $200,000 of average equity is 20 percent. Write it as a percent so the rate is easy to compare across years.

Stay with leftover profit in the numerator. Swapping in revenue turns this into a sales-against-equity reading, which is not this page.

Funding with debt can make this percent look higher, because the denominator is equity only. Notes payable and other loans sit outside this reading even though leftover still has to cover the interest.

Do not treat a high percent as proof the cash is in the till. Net income can sit in unpaid cafe invoices while last year's espresso machines are already paid for.

Adding a second location raises leftover profit only as the new shop fills. If the expansion was funded with new owner capital, the rate often dips in the first months.

This page stays on leftover against equity. Leftover against total assets, and operating profit against debt plus equity, belong on other pages.

Example

Two Cups Coffee runs a downtown shop and a neighborhood shop. Average equity for the year is $200,000, and net income is $40,000.

Divide: $40,000 by $200,000. ROE is 20 percent.

That 20 percent is leftover profit against the owners' stake. It is not leftover against the full asset base, which includes machines and inventory funded by vendors and a loan.

If the owners put in $50,000 of new capital late in the year and leftover profit stays $40,000, average equity rises and the rate falls. The stake got larger before it got more profitable.

If leftover profit rises to $50,000 on the same $200,000 of equity, the rate is 25 percent. The owners' claim did not change; the leftover did.

If half of that leftover is still sitting in unpaid wholesale invoices, the Income Statement rate can still be 20 percent. The cash reading would be lower until those invoices clear.

The company does not post a line that says this rate. The books already hold net income and equity; you divide.

Common mix-ups

This rate is not the same as return on assets. Return on assets divides leftover profit by total assets, so a shop funded with debt can read lower there than here.

This rate is not the same as return on invested capital. That reading uses operating profit against debt and equity together; this page uses leftover after interest against equity only.

This rate is not the same as cash in the till. A 20 percent reading can sit in unpaid invoices while last year's machines are already paid for.

Related terms

• Net Income: What is left from revenue after every expense, including interest and taxes, is subtracted.
• Equity: The owners' residual claim on the business after liabilities are subtracted from assets.
• Return On Assets: Net income measured against total assets.
• Book Value: The equity value carried on the balance sheet rather than a market value.
• Debt-To-Equity Ratio: Total debt measured against owner equity.
• Retained Earnings: Cumulative profits kept in the business rather than paid out.
• Return On Invested Capital: Operating profit measured against the debt and equity funding the business.
• Balance Sheet: A statement showing what a business owns, what it owes, and what is left for owners at a single point in time.