Definition: The Return on Equity Ratio shows how efficiently the company utilizes the shareholder’s money in generating the revenues for the firm. The investors are more concerned with this ratio, as they want to see how their funds are being utilized by the company.
The return on equity ratio can be used by the company internally or by the investors to evaluate the effectiveness of the management in generating the profits relative to the shareholder’s funds. Ideally, the ROE should be compared with the other companies within the same industry because of the same business environment and the common customer base.
The formula to calculate Return on Equity ratio is:
Return on Equity Ratio = Net income / Average Shareholder’s Equity
Where, Net income = profit after tax and the Average shareholder’s equity = (Shareholder equity at the beginning + shareholder equity at the end of the financial year) / 2
A Higher value of return on equity ratio shows the better utilization of shareholder’s fund and a firm is able to generate more revenues without raising the additional capital.
Example: Suppose the shareholder’s equity as on 1 July 2013 and on 30 June 2014 were Rs 3,00,000 and Rs 2,50,000 respectively. The firm earned the revenues of Rs 50,000. Then return on equity will be:
ROE = 50,000/ 2,75,000 = 0.18 or 18%
[ Average shareholder equity =( 3,00,000 + 2,50,000)/2 = 2,75,000]