If you want to understand how efficiently a company uses its shareholders' capital, it’s worth taking a look at the Return on Equity (ROE). It’s one of the most important indicators for assessing a company’s financial performance. In this article, we’ll explain step by step what ROE is, how to calculate it, and what to watch out for when interpreting it.
What Is Return on Equity?
Return on Equity (ROE) describes the ratio between a company’s net income and its shareholders' equity. More specifically, it shows how much profit a company generates with the capital provided by its owners. The higher the return, the better the company appears to be managing its shareholders’ funds.
For example, imagine a company has €1 million in equity and generates a profit of €200,000 in one year. The ROE would then be 20%. This means the company earned €0.20 in profit for every €1 of equity.
How Is ROE Calculated?
The formula for calculating Return on Equity is straightforward and easy to remember:
What Do These Terms Mean?
- Net income refers to a company’s profit after taxes. This is the money that actually remains at the end.
- Shareholders’ Equity is the capital contributed by the company’s owners. This excludes loans or borrowed funds.
Let’s look at another example:
A company has €250,000 in equity and generates a net income of €30,000 during the fiscal year. The calculation would look like this:
(€30,000 ÷ €250,000) × 100 = 12%
This means the company earned €0.12 in profit for every €1 of invested equity.
How to Interpret Return on Equity (ROE)
Return on Equity is considered a key measure of profitability. It reflects how well a company is managing its resources. A high ROE is often seen as a positive sign: it suggests that the company is generating strong returns on shareholder investments.
However, interpretation isn’t always straightforward. ROE can sometimes be distorted, for instance, if a company makes a one-time profit by selling a building. In that year, the ROE may look excellent, but it doesn't reflect sustainable business performance.
Another issue: Companies can artificially boost their ROE by using very little equity and relying heavily on debt. This reduces the equity base over which the profit is calculated, making the ROE seem higher without real efficiency gains. This effect is known as leverage.
That’s why you should always view ROE in context (across multiple years or in comparison with similar companies in the same industry).
Common Interview Questions on Return on Equity (ROE)
1. How is Return on Equity calculated, and what does it indicate?
ROE is calculated by dividing net income by shareholders’ equity and multiplying by 100. It shows how much profit the company has generated with its owners’ capital. A higher ROE is better, as long as it’s not distorted.
2. What does an increasing Return on Equity over several years mean?
A rising ROE can indicate improved efficiency and higher profits. However, it could also mean the company has taken on more debt. That’s why the capital structure should also be examined.
3. What are the weaknesses or risks of using Return on Equity?
ROE can be overstated due to one-off gains or a low equity base. In companies with high debt, profits are spread across a smaller equity base. In such cases, ROE provides limited insight into actual performance.
4. What is the difference between Return on Equity (ROE) and Return on Investment (ROI)?
ROE considers only the ratio of profit to equity. ROI, or Return on Investment, includes both equity and debt. It reflects how efficiently the total capital has been used, not just the owners’ capital.
👉 In our Case Library, you’ll find realistic finance and valuation exercises to practice interpreting key performance metrics like ROE.