Return on Equity Financial Ratio and QuickBooks 2012 - dummies

Return on Equity Financial Ratio and QuickBooks 2012

By Stephen L. Nelson

The return on equity financial ratio is one of several profitability ratios you can use along with QuickBooks 2012 to analyze your profitability. The return on equity financial ratio expresses a firm’s net income as a percentage of its owner’s equity or shareholders’ equity (shareholders’ and owner’s equity are the same thing).

The formula, which is deceptively simple, is as follows:

net income/owner’s equity

In the case of the example business described in the following tables, the net income equals $50,000, and the owner’s equity equals $200,000.

A Simple Balance Sheet
Cash $25,000
Inventory 25,000
Current assets $50,000
Fixed assets (net) 270,000
Total assets $320,000
Accounts payable $20,000
Loan payable 100,000
Owner’s equity
S. Nelson, capital 200,000
Total liabilities and owner’s equity $320,000
A Simple Income Statement
Sales revenue $150,000
Less: Cost of goods sold 30,000
Gross margin $120,000
Rent 5,000
Wages 50,000
Supplies 5,000
Total operating expenses 60,000
Operating income 60,000
Interest expense (10,000)
Net income $50,000

This firm’s return on equity, therefore, can be calculated by using the following formula:


This formula returns the value of 0.25, which means that this firm’s return on equity is 25 percent — a number that’s probably pretty good.

No guideline exists for what is and is not an acceptable return on equity.

  • The return on equity ratio that you calculate needs to be at least as good as you deserve. If you are investing money in your business, you deserve a return on that money. And that return needs to be reasonable compared with your other alternatives.

    If you can go out and invest money in a stock market mutual fund and get 10 percent, you shouldn’t be investing in things that deliver a return of less than 10 percent.

    Therefore, if you want to earn a 20 percent return on the money that you’ve invested in your own firm (by the way, a 20 percent return is a very reasonable return for a small business), you want to make sure that your return on equity (after you get going) exceeds this minimum return.

  • The return on equity ratio hints at the sustainable growth rate that your firm can manage. Sustainable growth is the growth rate that your business can sustain over a long period of time: three years, five years, ten years, and so on.

    If you don’t take money out of the business (other than your salary) and you reinvest the return on equity that the business generates, the return on equity ratio equals your sustainable growth.