Anyone who buys stock in your company hopes you'll use their investment to make more money. Return on equity (ROE) is a way to measure that. You measure ROE by dividing the owners' stake in the company into net income. If your income for the year is $50,000 and owners' equity is $500,000, ROE equals 10 percent. ROE may rise or fall as different factors come into play.
Equity and ROE
You find owners' equity on the company's balance sheet. The value of the total assets equals the total liabilities plus owners' equity. Subtract the liabilities from the assets and equity is what remains. If, say, you have $500,000 in assets and $200,000 in liabilities, the equity is $300,000.
Return on equity is important because a steady flow of income increases the company's assets, growing the value of the owners' share. In the United States and the UK, ROE averages around 10-to-12 percent. If you want to measure whether your ROE is good, comparing it to the average for your industry may be a better benchmark.
ROE and Management
If ROE is growing, that's typically a sign of good management. The company's earning a profit on its assets, and the profits are increasing over time. If you reinvest the money in the company, that increases the total assets, which in turn increases shareholders' equity. If ROE drops, that's often a sign management is making poor reinvestment decisions or not generating enough income.
Management isn't the only factor that affects ROE. For example, some companies take on debt to buy back stock from the owners. Because that reduces the total equity in favor of liabilities, ROE goes up even if net income doesn't change.
The downside? Taking on debt means paying back the loan, plus interest. If the market goes south, that can leave the company struggling to keep up the payments and seeing profits sucked up to pay the interest.
Even without a stock buyback, a company can use debt to buy new assets. If that increases net income, ROE goes up. But like buying back stock, the debt can drag down the company's performance, slowing ROE to a crawl.
ROE will also grow if the company writes down its assets because they're overvalued. As the total asset value shrinks, so does owners' equity. If income remains the same, ROE becomes higher even though the company hasn't changed anything but the bookkeeping.
Fraser Sherman has written about every aspect of business: how to start one, how to keep one in the black, the best business structure, the details of financial statements. He's also run a couple of small businesses of his own. He lives in Durham NC with his awesome wife and two wonderful dogs. His website is frasersherman.com