# Return On Equity Ratio

Another profitability ratio based on the investments is the return on equity ratio. Also referred to as Return on Net Worth, it is expressed as a percentage. Return on equity measures the profitability of equity funds invested in the firm. This ratio calculates the profitability of the owner’s funds invested in the firm. It measures the amount of profits earned out of shareholder’s invested capital. It is calculated as:

Net Income after Tax
Average Shareholders' Equity

The company's shareholders include preference shareholders and equity shareholders. The term shareholder's equity includes
• Preference share capital,
• Ordinary shareholders' equity consisting of
• Equity share capital
• Reserves and surplus.
The above formula gives us the return on total shareholder's equity. If, however, preference dividends are deducted from the net income and the resultant net income is divided by the equity belonging to the ordinary shareholders, we get return on ordinary shareholders' equity. As a common practice, return on equity is generally meant as return on ordinary shareholder's equity only. We must therefore deduct preference dividends from the net income while computing the ratio.

Net Income after Tax – Preference Dividends
Shareholders' Equity

A higher return on equity is a better sign and must be compared with the industry norm and the previous year's data for the same company to arrive at a meaningful conclusion.

Example:

Assume that a company has reported a net profit after taxes amounting to \$75,134. Its ordinary share capital is \$20,000 and accumulated profits \$850,000. The return on equity for the company would be:

\$75,134
\$20,000 + \$850,000

=> 8.64%

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