Return On Equity

Put simply, return on equity is net income divided by owners equity. Because it does not include creditors capital, the return on equity ratio shows the return from owners capital alone. The return on equity calculation is often refined by using average equity ((beginning equity plus ending equity)/2) in the denominator, because net income is generated over the entire reporting period. Other analysts subtract out preferred stock, which often resemble bonds, from the denominator in return on equity. Return on equity can be broken down into three components: Net Margin (net income/sales) X Asset Turnover (sales/assets) X Leverage (assets/equity). Sales and assets are in both numerator and denominator of the equation, so they cancel each other out and leave just the original return on equity ratio. If management can increase profitability (net margin) or efficiency (asset turnover), it can increase return on equity; it can also boost return on equity by using borrowed capital to increase returns (leverage). As with other financial ratios, a company's return on equity is best compared with those of firms in its industry.