Return on Equity – an Excellent Metric for Decision Making

The return on equity is an excellent measurement for small businesses to use to monitor how their businesses are going.  The return on equity is determined by dividing the net income for the year by the average equity (beginning equity plus ending equity divided by 2) for the year.  This Wikipedia site (click here) provides more on the definition.

Searching the Internet can find commentary on the value of the return on equity measurement.  For example, an article by Timothy Vick associates success of many companies with a high return on equity percentage.   Click here to read this article (PDF file).  Another article, by Richard Teitelbaum, Kimberly McDonald, and Ed Brown, does the same.  Click here to read this article.

Researchers have shown a relationship between a company culture, as defined by the researchers, and higher returns on equity.  Lorraine Eastman, Christopher Kline, and Robert Vandenberg show that companies with certain cultural characteristics have higher returns on equity.  Click here to read this article (PDF file).    Richards Barrett demonstrates the same conclusion.  Click here to read his information (PDF file).

The return on equity measurement is easy to make.  Net income is quickly obtained from the profit & loss statement and average equity can be computed from the equity balances at the beginning and ending of the year, obtained from the balance sheet for those dates.

Another useful return on equity attribute is that three other measurements, net income as a percentage of sales, sales as a percentage of total assets, and total assets as a percentage of average equity, can be targeted for improvements.  As each of these ratios are improved (increased percentages), the return on equity will increase.  This is because (net income/sales) X (sales/total assets) X (total assets/average shareholder equity) equals net income/average shareholder equity (which is return on equity), when the numerators and denominators in the equation cancel one another out.  So, a company can target anyone, or all three, of these percentages for improvements, and by doing so, will increase the return on equity.  Such actions as reducing costs while maintaining the same sales amount or selling assets but maintaining the same sales amount will increase the return on equity.

Companies should stride to increase their returns on equity. This site (click here), maintained by Aswath Damodaran, at New York University, provides average returns on equity for about 98 business sectors.