Return on equity is a key ratio that shows how much a company’s owners receive in return on the capital they have invested in the business. It is often used to assess how effectively management uses equity to generate profit.
Calculation
Return on equity is typically calculated as:
Return on equity = (Net profit for the year / Average equity) × 100
Where:
- Net profit for the year is the company’s profit after tax.
- Average equity is the average of equity at the beginning of the year and at the end of the year.
Interpretation
A high return on equity means the company is good at generating profit from the capital the owners have tied up in the business. A low or negative return on equity may, conversely, indicate that the capital is not being used efficiently, or that the company has made a loss.
However, it’s important to compare the metric with companies in the same industry, as capital structure and risk level can vary significantly.
Example
If a company has a profit after tax of DKK 2 million and an average equity of DKK 10 million, the return on equity will be:
(2.000.000 / 10.000.000) × 100 = 20 %
This means the owners have achieved a 20% return on their invested capital.
Use
Investors, banks and owners use return on equity to:
- Assess whether the company provides an attractive return compared with alternative investments.
- Analyse the company’s historical development in returns.
- Compare companies in the same industry.