Return on Equity Analysis
In this lesson, we will learn how to calculate the return on equity ratio and interpret based on the ratio if an owner should continue investing in the business.
Related Lessons:
Calculating & Interpreting Return on Equity
The return on equity ratio measures the percentage of return an owner or investor can receive from his/her investment in the business.
This ratio is important to owners and investors as it helps them assess whether to continue investing in the business or to move their capital to other investments that offer a higher return.
To calculate, we take Profit for the year divided by Average Equity and multiply the answer by 100%. This gives us the percentage of return that the owner or investor received from the business.
(Profit for the year / Average Equity) x 100% = x%
Average Equity is calculated by taking Beginning Equity plus Ending Equity and divide the answer by 2.
(Beginning Equity + Ending Equity) / 2
Assuming a return on equity of 10%. This means that the owner / investor earns $0.10 for every $1 of capital invested in the business.
Generally, a high return on equity or an increase in it suggest that the business is profitable.
To determine whether the return on equity ratio is acceptable, the owner or investor should compare it with the return on equity of similar businesses or with other investment options available to them.