The Return on Equity Ratio (ROE) measures how effectively a company generates profits from its shareholders’ investments. It indicates management’s efficiency in utilizing equity financing to generate higher sales, profits, and, thus, returns to investors.
Primary Implication
The Return on Equity Ratio tells you how much money the business owners make on their company investment. It is not a reflection of the company’s investment in assets.
ROE measures the ability of a company to generate profits on each dollar of common stockholders’ equity. A growing ROE indicates how effectively management has used their investors’ money to fund operations and grow the company. A low ROE means investors aren’t receiving a return on their investment.
Overview
The Return on Equity Ratio (ROE) is a Profitability Ratio that reflects how much money is made based on the investors’ investment in the company, not the company’s investment in assets, or something else. ROE measures the ability of a company to generate profits from its shareholder investments by showing how much profit is generated by each dollar of common stockholders’ equity.
ROE is especially important for potential investors, who want to know how efficiently a company will use their money to generate net income. ROE also indicates how effectively management uses equity financing to fund operations and grow the company.
The formula for Return on Equity Ratio is as follows:
Net Income / Owners’ Equity
A ratio of 1 means that every dollar of equity generates one dollar of sales. A 1.8 ROE means that every dollar of equity earned $1.80 or 180% return to owners on their investment.
Higher is Better: indicates that the company uses its investors’ funds effectively.
Lower is Worse: this means that the company isn’t growing, and owners aren’t receiving a return on their investment.
Anytime you use other people’s money to capitalize your business, you enter into financial and management obligations to those who provide you money. You must be particularly careful equity investors. You must do something more with their money than the cost of the money, or they will exercise their rights to throw you out of your business to protect their investment.
