Return on Equity (ROE): How to measure profitability

Return on equity shows the profitability a company generates on its owners' book value capital. This key figure is also known as ROE, or “return on equity”.

Formula

A common calculation is:

Return on Equity = Net Profit / Average Equity × 100

Average equity is often calculated as equity at the start plus equity at the end of the year, divided by two. Some calculations use profit before tax. The definition must therefore be specified.

Example

If the net profit is 1 million Norwegian Kroner and the average equity is 5 million, the return on equity is 20 percent. This does not mean that the owners necessarily receive 20 percent; the profit can be retained in the company.

High returns can mean high risk

A high percentage can be due to good operations, but also very low equity and high debt. Debt financing can boost owners' returns in good years and amplify losses in weak years. Therefore, check the debt ratio, equity ratio, and interest expenses.

With negative or near-zero equity, the key figure can become less meaningful. Large capital injections, dividends, or one-off items can also make the one-year calculation difficult to interpret.

How to compare

Look at the development over three to five years and compare it with businesses in the same industry. Assess whether the return is based on stable profitability or temporary gains. Cash flow should support the result over time.

Return on equity on Proffi

Proffi should display both the percentage and the figures behind the calculation. If average equity cannot be calculated, an alternative method must be marked. In the case of negative equity, the system should show “not meaningful” rather than a misleading percentage.