Shareholders' equity indicates the amount owners have invested in the business. To calculate the rate of return on stockholders' equity, a company must take its net income and divide it by average business equity. A company's average business equity can be computed by adding beginning equity to ending equity. Return on shareholders' equity indicates how well a company has used equity to finance the company's business operations. A high return on equity indicates a company's efficient use of assets invested by owners to increase the value of the business, as explained by the Business Accounting Guides website.
Add a company's beginning shareholders' equity to its ending shareholders' equity. Let's assume a company has beginning shareholders' equity of $200,000 and ending shareholders' equity of $400,000. Add $200,000 to $400,000, which results in a total of $600,000.
Divide beginning equity and ending equity by two. This calculation indicates a company's average business equity. Using the above example, divide $600,000 by 2, which results in $300,000.
Review the company's income statement to determine net income. A company's net income should appear on the income statement. Net income is a company's total revenues subtracted by expenses like depreciation, interest and cost of sales.
Divide net income by average business equity. Let's say a company has net income of $120,000. Using the average equity calculation from Step 2, divide $120,000 by $300,000. In this scenario, return on shareholders' equity equals .40 or 40 percent. Compare the return on equity ratio with the return on equity of other businesses in the same industry to properly assess the financial health of the company.
Items you will need
- Income statement