What it means
Equity, also called net worth or shareholders' funds, is total assets minus total liabilities, and it includes both the capital originally paid in and the profits retained over the years. Dividing net profit by that figure tells owners whether their stake is working harder than it would elsewhere.
Because profit accrues over a year, the average of opening and closing equity gives a fairer answer than the year end balance. Investors care about this ratio more than almost any other because it is directly comparable with the returns available on other investments.
If a business consistently returns 5% while a low risk alternative pays similar rates, the owners are carrying commercial risk for no additional reward. The measure has one important quirk that catches people out.
Borrowing money increases the ratio when things go well, because debt funds extra profit without increasing equity, so a highly geared company can post an impressive figure while carrying real fragility. This is financial leverage at work, and it magnifies losses just as effectively as it magnifies gains.
Analysts therefore break the ratio into its three drivers: profit margin, asset turnover and financial leverage. Multiplying net profit margin by asset turnover by the ratio of assets to equity reproduces return on equity, and looking at each part separately shows whether the return comes from trading skill, asset efficiency or simply from debt.
A final caution concerns the denominator. Companies that have bought back their own shares or accumulated large losses can have very small or even negative equity, which produces ratios that are meaningless or impossible to interpret, so the underlying balance sheet should always be checked.
In practice
Real-world examples.
Example
A family manufacturing business returns 22% on equity while a listed competitor returns 14%. The family firm's advantage disappears once analysts note it rents its factory rather than owning it, which keeps equity small.
Example
A private investor comparing two potential acquisitions finds both earn $400,000 of profit. One requires $1,600,000 of equity for a 25% return and the other $4,000,000 for 10%, which settles the decision quickly.
Example
A construction company posts a return on equity of 30% in a strong year and 4% in the next. The volatility reflects heavy borrowing, and its bank asks for stronger covenants as a result.
Think of it
“Net profit to equity shows what return shareholders earn on their investment-ROE.
Formula
Calculation
Net profit to equity ratio = (net profit / average shareholders' equity) x 100, where average equity = (opening equity + closing equity) / 2
Alderton Fabrics reports net profit of $1,260,000 for the year. Shareholders' equity was $6,600,000 at the start of the year and $7,400,000 at the end, after retaining part of the profit.
Average equity is ($6,600,000 + $7,400,000) / 2 = $14,000,000 / 2 = $7,000,000. The ratio is ($1,260,000 / $7,000,000) x 100 = 18%.
For comparison, if Alderton's total assets averaged $14,000,000, its return on assets would be ($1,260,000 / $14,000,000) x 100 = 9%. The gap between 9% and 18% comes entirely from financial leverage, since assets are twice the size of equity.Case study
Seen in the real world.
The following is a fictional example created purely for illustration. Marbury Fitness Group, an invented operator of eight gyms, reported return on equity of 28% and used the figure in a fundraising deck as evidence of exceptional performance. A prospective investor decomposed the number before committing.
The breakdown was revealing. Net profit margin was a modest 5%, asset turnover was 1.1 times, and assets were more than five times equity because the estate had been funded almost entirely with debt. The impressive headline return came mainly from gearing, not from unusually good trading.
In this illustrative scenario the investor still invested, but on different terms: fresh equity was used to repay $3,000,000 of the most expensive debt. Return on equity fell to 17% on paper, yet the fictional business survived a subsequent downturn that would have breached its old covenants, and the investor regarded the lower ratio as the better outcome.
Watch out
Common mistakes.
- Treating a high return on equity as proof of a strong business without checking how much of it comes from borrowing rather than trading.
- Using year end equity instead of the average, which understates the return in a year when a large amount of new capital was raised late.
- Calculating the ratio for a company with negative equity and reporting the resulting figure as though it meant something.
Questions
People also ask.
Is this the same as return on equity?
Yes, return on equity is the usual name for this ratio and the calculation is identical.
How does it differ from return on assets?
Return on assets measures profit against everything the business uses, while this measures profit against the owners' share alone, so the gap between them reflects borrowing.
What counts as a good level?
Many established businesses target somewhere between 12% and 20%, but the right answer depends on sector risk and on what the owners could earn elsewhere.
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