Return on equity ratio, or ROE, is a profitability ratio that helps measure the efficiency of a firm and its management in handling shareholders’ money. The ratio gives an insight into the ability of the firm to generate profits from shareholders’ investment. It is calculated by dividing the net income by shareholders’ equity.
In simpler words, the return on equity ratio shows how much profit each rupee of stockholder money generates. For instance, an ROE of 1 means that every rupee of shareholder investment in the business would generates Re 1 net income. It is a measure of how effective the management is in using equity financing to fund its operations. Thus, the higher the ROE, the more efficient is the management in generating income and growth from its equity financing.
ROE is an important indicator for potential investors, since they want to see how efficiently a company will use their money to generate profit. The ratio is often used to compare health of a business with its peers and the broader market. The formula is especially beneficial when comparing firms within the same industry, since it tends to give accurate indications on which companies are operating with greater financial efficiency. That can help evaluate any company with primarily tangible rather than intangible assets.
Formula for calculating ROE:
Return on Equity = Net Income or Profits/Shareholder’s Equity
Shareholders’ equity is the difference of firm’s assets and liabilities. It is the sum left over if a company decides to settle its liabilities at a given time.
Source: Economic Times