How to calculate return on equity
How to calculate return on equity (ROE): the full guide
As an ambitious startup founder, there's little doubt that you're hungry to scale your venture and showcase your product, service or solution to the world post-haste.
But, to stay on the well-trodden path to success, getting your finances and investments in order is essential. When it comes to steering a startup to success, there’s a steep learning curve – there are many fiscal plates to juggle and endless metrics to track.
Without doubt, one of the most valuable financial metrics to get a handle on as a growing startup is return on equity.
This important metric is incredibly valuable for evaluating your investment returns and understanding your company’s ability to generate profits.
Getting to grips with return on equity can seem a little daunting at first – but it’s simpler than you think, and we’re here to help guide you through the process, starting by looking at what ROE is and why it’s important.
Ready? Let’s get started.
Table of contents
- What is return on equity (ROE) and why is it important?
- How to calculate return on equity?
- How to improve your company’s ROE
- Return on equity FAQ
- Try our user-friendly return on equity calculator
What is return on equity (ROE) and why is it important?
Return on equity is a reliable means of quantifying your startup’s annual return – or net income – which is divided by your shareholder’s income or equity. Another way of calculating your ROE is to divide your company’s dividend growth rate by its earnings retention rate.
Return on equity = Net income / Shareholders’ equity
As your shareholders’ equity equates to your business’s assets minus its existing debt, ROE is typically considered an overall return on net assets.
When you’re exploring your ROE, it’s vital that you consider these two aspects:
Your net income is the cash or income you have to spend minus tax payments, expenditure, and various contributions. This figure is a key factor when calculating your ROE and measuring your company’s ability to generate profits, both internally and externally.
Shareholders' equity is the remaining amount of assets available to your shareholders after every one of your liabilities is settled. This metric is usually calculated either as a company's total assets less its overall liabilities.
As a key component of your ROE calculations, shareholders’ equity, as a divisor to your net income (or annual return) will give you a clear indication into your startup’s ongoing financial efficiency and ability to grow.
Knowing your return on equity is critical. Not only will this handy calculation outline your profit generating powers, but it will also help you benchmark your fiscal performance against other firms or companies in your industry.
If your startup has a solid return on equity, you can demonstrate that:
You’re an attractive and potentially lucrative venture for new investors. You will also appease preferred shareholders
You’re able to use shareholder equity effectively and reliably
You have steady revenue streams and you’re good at retaining your earnings
You have a significant economic moat and can protect your long term profits as well as your market share
How to calculate return on equity?
Now we move onto the big question – how to calculate ROE. We’ve already covered the basic ROE equation and to illustrate the point further, we’re going to look at a practical example based on the “Return on equity = Net income / Shareholders’ equity” model.
Return on equity calculation example
Say, for instance, you're a fast-scaling SaaS startup with an annual net income of $2,000,000 plus average shareholder equity of $15,000,000. Colossal numbers, but it doesn't hurt to dream big, right?
Now, for this SaaS it's possible to calculate ROE by dividing net income and average shareholders' equity, like so:
2,000,000 / 15,000,000 = 13.33%
Armed with this figure on your company’s balance sheet, you can compare your ROE with direct competitors as well as previous fiscal years based on your internal benchmark (a realistic ROE percentage) to gain a deeper understanding of your financial efficiency and overall performance concerning profit generated and managed.
How to improve your company’s ROE
To strike the perfect balance between your net income and shareholder’s equity – or in other words, boost your company’s ROE – there are certain tactics you can explore.
There are several ways of boosting your ROE in today’s fast-paced business environment – and these are among the most effective.
Boost your profit margins
First and foremost, you can improve your ROE by strategically raising your profit margins. As profit (or net income) is one of the primary driver’s of calculating your ROE, increasing your margins in certain areas of the business in relation to your shareholders equity will ultimately make your ROE healthier.
The good thing about this approach is the fact that you don’t have to boost your profits from selling more products alone. Here are some of the ways you can boost your margins for success:
Raising the prices of products that sit in a popular category or selling well
Lowering the costs of your goods sold by making deals with your current suppliers or sourcing new ones
Driving down your overhead expenses in certain areas of the business
By strategically increasing your profit margins, you will improve your net income and ultimately, enhance your ROE.
Enhance asset turnover
Asset turnover is a metric that measures a business’s general efficiency. Typically, the more sales you make in relation to its assets, the more profitable you're likely to be – and the better return on the equity you should see.
To improve your asset turnover, you should aim to operate as efficiently as possible across the board, particularly when it comes to fulfillment and inventory management. If you handle your stock well, select inventory that is likely to shift (without over- or underordering), and plan your merchandising or fulfillment strategies in advance using the right data, you will optimize your asset turnover. And, doing so will have a positive impact on your equity ratio.
Distribute idle funds or cash
Idle funds or cash is becoming a pressing issue for scaling businesses, particularly startups in the technology or recurring revenue sector.
When funds or cash sit idle in excess of what you really need, it can make your profits appear more limited. That said, by making your idle cash more mobile, you will make your company’s balance sheet look more balanced, improving your equity ratio in the process.
The best way to do this is to distribute a certain portion of your idle cash to your shareholders: a simple yet effective tactic.
Work with the right tools
We live in a data-driven digital age where you can access a wealth of invaluable insights with the swipe of a screen or the click of a button.
If you work with platforms that give you access to invaluable data visualizations and financial metrics with ease, you will be able to boost your financial efficiency in a number of key areas that will have a positive impact on your ROE.
Tools also exist to help you make vital financial calculations with maximum accuracy and minimal effort – which brings us onto our next point.
Return on equity FAQ
What is considered a solid return on equity for a UK business?
You know the importance of calculating your return on equity and the benefits of maintaining a healthy ROE – now let’s look at what makes a solid figure.
There is no universally valid range for a decent return on equity. Different industries tend to have different return on equity sweet spots – so you should set your ROE benchmark depending on your specific niche or sector. It also follows the fluctuations of the economic trends.
Typically, ROE is expressed as a percentage and as a general rule of thumb, a steadily growing return on equity is considered a good indicator of an attractive investment opportunity across industries.
While this may be the case, doing your research and discovering what makes a solid ROE in your industry will help you build solid foundations for your company’s calculations. Generally speaking, the higher your ROE, the better – and if you’re able to grow your ROE year on year, you’ll know that your company is heading in the right direction concerning its market growth as well as its net income generated.
How does ROE affect stock performance?
Companies usually calculate sustainable growth rates or dividend growth using ROE based on the notion that the ratios fall roughly within or just above peer groups' average.
While this process can prove challenging, ROE can form solid foundations when developing prospective growth in a company's shares and dividend rates. The rate at which companies can expect their earnings to rise depends on how much they retain their workforce.
The retention ratio is based on how much cash your company stores in the stock or invests in future growth. Both of these mathematical functions complement one another and as such, may allow comparison among similar companies with relative ease.
Try our user-friendly return on equity calculator
As you will now know, a high ROE is a positive indication of your level of profits generated as well as the value of your various business initiatives and strategies (from customer retention and stakeholder management to sales, marketing, fulfillment, and beyond).
While working out your return on investment is typically straightforward, working with the numbers and checking your calculations can take time.
To ensure your ROE equation calculations are 100% accurate – and to afford you time on a wealth of vital business-boosting activities – here at Bloom HQ, we’ve developed a tool just for you.
Our cutting-edge ROE calculator is swift, simple, and it will help you manage your company’s balance sheet with complete confidence.
Use our return on equity calculator to monitor your ROE on a regular basis and get to the root of any potential issues or variables that may be stunting your fiscal progress or affecting, well, your return on equity.
We hope you found this ROE calculation guide helpful. If you have any questions or you want to know more about what Bloom can do for you, get in touch. We’re always here to help.
Get Bloom funding
Don't get diluted
See how much you qualify for with no commitment