Return on Equity (ROE) Ratio Analysis

Definition: Return on Equity (ROE) ratio (also refereed to as return on net worth) measures the amount of profit that a company generates through the use of shareholders' equity (also known as net assets or assets minus liabilities).

Formula:

Return on Equity Ratio = Net income after tax / Average shareholders equity
Or,
Return on Equity has three ratio components:
ROE = Profit Margin * Asset Turnover * Financial Leverage
ROE = (Net Income / Sales) * (Sales / Assets) * (Assets / Equity)

Example 1:
CPM Company has net income before taxes $20,000, income taxes $2,000, and $90,000 in average shareholders' equity.
Then, Net income after tax = 20,000 - 2,000 = $18,000
Return on equity = $18,000 / $90,000 = 20%
This means that the company has $0.20 of net income generated for every dollar invested by shareholder.

Example 2:
Golden Ltd. has the following data:
Sales for the year $30,000
Average total assets $35,000
Net Income for the year $4,500
Average shareholder equity $20,000
Then,
Profit Margin = 4500 / 30000 = 0.15 = 15%
Asset Turnover = 30000 / 35000 = 0.86 = 86%
Financial Leverage = 35000 / 20000 = 1.75 = 175%
ROE = Profit Margin * Asset Turnover * Financial Leverage = 0.15 * 0.86 * 1.75 = 22.575%

* Next: Return on Investment Ratio Analysis
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Kelvin Wong Loke Yuen is an experienced writer with a strong background in finance, specializing in the creation of informative and engaging content on topics such as investment strategies, financial ratio analysis, and more. With years of experience in both financial writing and education, Kelvin is adept at translating complex financial concepts into clear, accessible language for a wide range of audiences. Follow him on: LinkedIn.

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