Return on equity (ROE) measures how effectively a business turns shareholders’ equity into profit, expressed as a percentage. For accountants, advisors, and finance executives, it’s one of the quickest ways to determine whether the company’s strategies are yielding sufficient returns in relation to the owners’ investments. While low or declining ROE may indicate margin pressure, poor asset utilisation, or an ineffective capital structure, high or improving ROE may indicate strong profitability, operational efficiency, or effective use of leverage.
This KPI glossary explains the return on equity formula, how to calculate it through a step-by-step example, its application in performance assessment, and how businesses can use ROE to identify opportunities for improvement or potential risks.
According to the Corporate Finance Institute, return on equity is used in corporate finance as a core measure of how effectively a company generates returns on shareholders’ capital.
Several factors that influence the return on equity:
A “good” or “bad” return on equity depends on industry standards, business maturity, and peer benchmarks (as noted by sources like Investopedia), which is why understanding what is return on equity ratio in context is important for accurate interpretation.
For example, a company with a high ROE may be generating strong earnings relative to its equity base. However, ROE can also be inflated by excessive leverage. This is why it’s important to examine metrics such as the debt-to-total-assets ratio when interpreting return on equity.
The return on equity has multiple strategic purposes for businesses:
To find out how to calculate the return on equity, you use the formula below:
Return on equity = Annualised net income / Opening total equity x 100
This rate of return on equity formula focuses on the opening equity balance, which helps standardise period-to-period comparison.
To calculate return on equity, follow these steps:
As an example, you can apply the rate of return on equity formula like below:
Company A reports:
Using the rate on equity ratio formula:
Return on equity = (420,000 / 2,400,000) x 100 = 17.5%
The 17.5% ROE shows that the business generated 17.5 cents of profit for every $1 of equity invested at the start of the period.
Return on equity is widely used across financial analysis because it offers a simple but valuable connection between earnings and the capital base needed to generate those earnings.
When evaluating a business, the rate of return on equity formula helps provide answers to questions such as:
A consistently high ROE typically indicates that the business is competitively positioned, runs effectively, and makes wise capital allocations.
A declining or inconsistent ROE, on the other hand, might be a sign of more serious problems like margin pressure, bad investment choices, a weakening balance sheet, or declining asset productivity.
The sustainable growth rate (SGR) is closely tied to return on equity because it gauges how quickly a business can expand using internally generated funds without needing additional external equity.
The traditional model is:
SGR = Return on equity x Retention ratio
The retention ratio represents the proportion of profits reinvested back into the business.
For accounting professionals and advisors, SGR is valuable because it:
A business with high ROE and a high retention ratio may be capable of growing rapidly without putting strain on its balance sheet. However, a company with modest ROE but high reinvestment may be destroying value if returns fail to exceed the cost of capital.
Return on equity also plays a central role in estimating future growth potential.
Return on equity is used to connect profitability with growth assumptions in valuation work, particularly in discounted cash flow, dividend discount models, and residual income models. If the company's capital structure and margin performance stay constant, a steady and well-supported ROE suggests that earnings growth may continue at a consistent rate.
When using return on equity as a growth predictor, it’s important to consider:
Even though the return on equity metric is a reliable predictor of future growth, it shouldn't be used alone. When ROE is combined with cash flow performance, ROA, ROIC, and operating profit margin, it allows a more holistic understanding of long-term earnings capacity.
Return on equity becomes significantly more insightful when used for benchmarking. Because industries vary in capital intensity, cost structure, and profitability models, ROE norms differ widely.
For example:
Hence, when comparing ROE across businesses, you should consider:
Context is necessary when interpreting the return on equity ratio, especially because ROE norms differ across industries. Generally:
Nevertheless, return on equity should be reviewed further alongside EBIT margins, cash flow quality, and other asset efficiency ratios for a well-rounded assessment.
Other than being a performance metric, return on equity also acts as a lens to flag any emerging risk areas and uncover other structural issues.
ROA measures profitability relative to total assets, whereas ROE focuses on equity only.
ROA formula = Annualised earnings before interest and tax / Total assets x 100
ROA is less affected by leverage and reflects operational efficiency regardless of capital structure. Comparing ROA and ROE can reveal how heavily a firm depends on debt.
ROIC measures returns generated from all long-term capital (debt and equity).
ROIC is useful because it reflects total investment efficiency and removes distortions caused by capital structure. For instance, a company with high ROE but low ROIC often relies too heavily on debt.
These comparisons provide context for interpreting the return on equity ratio formula in a broader performance framework.
DuPont analysis expands the return on equity into three key drivers, offering a deeper look at the underlying performance factors.
The DuPont formula is as follows:
Return on equity = Net profit margin x Asset turnover x Equity multiplier
Where:
This helps you identify whether the return on equity improvements come from:
Return on equity is a powerful metric, but it has limitations that you must consider when interpreting results.
Understanding return on equity is more than just calculating a single ratio. Beyond the fundamentals, Fathom's dedicated profitability analysis tool offers powerful insights into how a business is managing its major expenses and costs of sales.
Through Fathom’s profitability tool, you gain a more strategic understanding of your client's capability to generate sustainable returns, empowering you to make smarter, sharper, and more confident recommendations.
Return on equity is an important metric in financial analysis, helping accountants, advisors, and investors evaluate performance, capital efficiency, and long-term sustainability. Although return on equity provides insight into how well a company turns equity into profit, it must be viewed alongside complementary metrics such as ROA, ROIC, leverage ratios, and industry benchmarks.
As part of a larger performance-measurement framework, return on equity can truly be a useful tool for assessing the financial health of a business, identifying risks, and driving strategic decision-making.
A “good” return on equity depends heavily on the industry. Generally, 10%–20% is considered healthy for many sectors. High-growth service businesses may exceed 25% or more.
Negative ROE occurs when net income is negative or opening equity is negative. It generally indicates poor profitability or financial stress.
ROE can rise due to higher net income, improved operating efficiency, better margins, and share buy backs that reduce equity.
ROE measures return to shareholders. ROA measures the return generated by total assets. ROA is less influenced by leverage and gives a clearer view of operational efficiency.
Investors use ROE to assess management effectiveness, evaluate long-term value creation, benchmark companies, and estimate sustainable growth potential.
Hamidah Abd Rahman is a content writer at The Access Group and Fathom. With a strong focus on B2B industries, she has written content across sectors such as data science, supply chain, aviation, and ERP.
