Shareholders' equity indicates the net worth of the business. Return on equity exists as a measure of profitability and efficiency. A company's return on equity demonstrates how well a company uses the investment made by owners to generate additional revenue. A company should compare its return on equity ratio with other businesses in the same industry to more accurately assess the financial health of the company. A high return on equity ratio illustrates that the company is using owner investments efficiently to add revenue to the business. This means the company is less likely to need loans to finance the company's operating activities.
Compute the company's net income. View the company's income statement, also known as a statement of profit and loss, to determine net income, since net income should appear on the income statement. Add total revenue. Subtract the cost of goods sold, along with any other expenses incurred during the period. Revenue minus expenses indicates the company's income before taxes. Subtract income taxes from the company's pretax income. The result yields the company's net income. For example, a company with $100,000 in sales has total expenses of $50,000. This means pretax income is $50,000. If the company has income taxes totaling $15,000, the company has a net income of $35,000.
Compute shareholders' equity from the balance sheet. If the company does not have a balance sheet, add all assets and subtract total assets by total liabilities. For example, a company with $35,000 in assets and $10,000 in liabilities has shareholders' equity of $25,000, since shareholders' equity equals assets minus liabilities.
Divide net income by average shareholder's equity to determine the return on equity. For instance, a company with a net income of $20,000 and shareholders' equity of $60,000 has a net income of .33, or 33 percent. Normally the company must add beginning equity with ending equity to determine the average equity. However, since this example focuses on a start-up company, the ending equity for the year is the average equity for the business.
Items you will need
- Income Statement
- Balance Sheet
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