I have an Accounting mid-semester exam coming up!! :| We need to study analysis of accounts and I and struggling with a few. How do you work out return on equity?Can somebody please give me the formula? Please explain how to do the calculation and where to get the figures from.
Return on equity provides owners with information on the percentage return or "profit" they have made on their investment over the year.
It is calculated as:
ROE = Net Income / Shareholders Equity
The "net income" figure is the calculated as the final amount in the income statement i.e. revenues less all expenses. The figure most commonly used is the profit after taxes and preference dividends have been deducted but before ordinary dividends have been paid. The reason that ordinary dividends are not deducted first is that these are a return to the owners so should therefore form part of the income used in the calculation.
Some accounts that can form part of Shareholders Equity are: Capital, Drawings, Retained Earnings, Ordinary Shares, etc. The total Shareholders Equity amount can be found in the Balance Sheet.
The ROE is express as a percentage. It can be useful in determining whether the investment has been successful for the individual shareholders. Often, average shareholders equity is used as the denominator. This is considered to be a more accurate representation of the return as the net income figure is an accumulation of profit throughout the year so it should be compared to shareholders equity throughout the year as well. The ending shareholders equity may not be good representation of the equity during the year if a major change such as a share issue or share buy back has taken place.
Average shareholders equity is calculated by adding the opening and closing figures (i.e. at the beginning and end of the year) and dividing the total by 2.