BUS601: Financial Management

Return on Equity

Return on equity measures the company's ability to use its invested capital to generate income. The invested capital comes from stockholders' investments in the company's stock and its retained earnings and is leveraged to create profit. The higher the return, the better the company is doing at using its investments to yield a profit. The formula for return on equity is:

$\text{Return on equity} = (\dfrac{\text{Net income}}{\text{Average Stockholder Equity}})$

$\text{Average stockholder equity} = (\dfrac{\text{Beginning stockholder equity + ending stockholder equity}}{2})$

Average stockholders' equity is found by dividing the sum of beginning and ending stockholders' equity balances found on the balance sheet. The beginning stockholders' equity balance in the current year is taken from the ending stockholders' equity balance in the prior year. Keep in mind that the net income is calculated after preferred dividends have been paid.

For Banyan Goods, we will use the net income figure and assume no preferred dividends have been paid. The return on equity for the current year is:

$\text{Average stockholder equity }= \dfrac{$90,000+$100,000}{2} =$95,000$

$\text{Return on equity } = \dfrac{$35,000}{$95,000} = 0.37 \text{ (rounded)  or 37%}$

The higher the figure, the better the company is using its investments to create a profit. Industry standards can dictate what is an acceptable return.

Source: OpenStax, https://openstax.org/books/principles-financial-accounting/pages/a-financial-statement-analysis
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