Profitability Ratios - Return on Equity

Return on Equity (ROE) measures the rate of return on the ownership interest (shareholders' equity) of the common stock owners. It measures a firm's efficiency at generating profits from every unit of shareholders' equity (also known as net assets or assets minus liabilities). ROE shows how well a company uses investment funds to generate earnings growth.

Return on Equity = Net Profit (after Tax) / Shareholder's Equity

Shareholder's Equity :-A firm's total assets minus its total liabilities. Equivalently, it is share capital plus retained earnings minus treasury shares. Shareholders' equity represents the amount by which a company is financed through common and preferred shares. 

Also known as "share capital", "net worth" or "stockholders' equity" or Shareholder's Fund".

Note:-  Return on Equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested.

Illustration :-

This is the Balance Sheet of Reliance Industries Limited as at 30 Sept 2010.

From the above Balance Sheet we have relevant information 

Shareholder's fund or Shareholder's Equity = Rs. 1,45,740 cr. (Capital + Share Application Money + Reserves & Surplus) or {(Total Assets = Fixed Assets + Investment + Current Assets, Loans & Advances) - (Total Liabilities = Loan Funds + Deferred Tax Liability/(Assets) + Current Liabilities & Provisions)}

From the above key highlights we have Net Profit (after Tax) as at 30 Sept 2010 


Net Profit (after Tax) = Rs. 4,923 cr.


So,
Shareholder's Equity = Rs. 1,45,740 cr.
Net Profit (after Tax) = Rs. 4,923 cr


Return on Equity =  Net Profit (after Tax) / Shareholder's Equity


Return on Equity = 4923 / 145740 = .0337 or 3.37%


Analysis :-


So, Return on Equity is .0337 means Company generates Rs. 0.0337 profit from every unit of Shareholder's Equity or 3.37% profit with money shareholders invested.