Definition: Return on equity, sometimes abbreviated as ROE, is a financial ratio that measures how profitably a company can use the money it gets from equity investors. In other words, it shows how well the company can make profits from the investments from shareholders. The return on equity ratio formula is calculated by dividing net income by shareholder’s equity for a period.
What Does Return on Equity Mean?
This is a particular important ratio for both investors and creditors. Investors are looking for companies that can take their money, invest it, and create even higher levels of net income. Creditors, on the other hand, want to make sure that the company is properly capitalized and running efficiently. Ultimately both groups want the same thing. They want to see the company use equity financing to produce greater profits to give investors an adequate return while meeting all of their current obligations to creditors.
Sometimes it’s easiest to look at an example. Let’s look at Carrie’s Kitchen, Inc. Carrie’s is a family owned restaurant that is looking to start a few franchises in neighboring areas. In order to do this, they have decided to take on a few new investors. Last year Carrie had a net income of $100,000. Carrie is the sole owner and she has only contributed $20,000 to the business since its inception.
Carrie’s return on equity equals $5. This means that for every dollar of equity Carrie has put into the company, the business generates $5. This return is quite high and potential future investors should be thrilled to help finance its expansion into neighboring cities.