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