Return on equity is a key financial metric for business owners.
It’s important because it is a measure of your returns as a business owner, the earnings you make on the money you have put into the business.
Think of it this way, if you could pick between only these two options, which option would you choose:
- A savings account paying 5% interest, or
- A savings account paying 15% interest?
Of course you would pick the second option. If you had $1 million in the bank it’s the difference between $50,000 and $150,000 in interest payments, per year.
It sounds simple, but that’s exactly how return on equity works.
When you own a business, you have equity invested in that business. Like the $1 million if it’s deposited at the bank, just invested in the working capital, property and equipment required to operate your business. That investment will generate earnings (hopefully!)
- If your return on equity is 5%, it means you are earning $50,000 in profits on your $1 million investment.
- If your return on equity is 15%, it means you are earning $150,000 in profits on your $1 million investment.
So return on equity is really important. If you could earn a better return simply by depositing your money in the bank, or in another investment, you probably should! The difference to a savings account is that where you can’t choose your interest rate with a bank, you can influence your return on equity by taking steps to improve it.
That’s why return on equity couldn’t be more important to a business owner, and why you should calculate it, monitor it and look to improve it at every opportunity.
In this post I’ll show you how to calculate your return on equity and the steps you can take to improve your all-important return on equity.
Let’s get right to it!
How to Calculate Return on Equity
To calculate return on equity, you start by taking your net profit after tax for the year and then divide that by your owner’s equity, which is your total assets less total debt. Here’s the formula:
Return on Equity = Profit After Tax / Owner’s Equity x 100%
Owners Equity = Total Assets - Total Debt
Nowadays, your bookkeeping or accounting software will calculate return on equity for you automatically. But It is still important to understand how it is calculated so you can interpret the results and understand its drivers.
Let’s use an example just to make it clear:
Your local pizza shop has a net profit after tax of $75,000 for the year. To operate the business the owner needs inventory, the restaurant fit out, a pizza oven, and other miscellaneous equipment. The value of these assets is $400,000 and they have $100,000 in debt from the bank, so the owner’s equity is $300,000. To calculate the return on equity we take the $75,000 in net profit after tax and divide by $300,000 in owners equity, giving us a 25% return on equity (75,000 / 300,000 * 100%).
How to Improve Return on Equity
We can find ways to improve return on equity by looking into its drivers. Looking at the formula used for calculating the metric, we can determine that there are two drivers of return on equity:
- Net profit after tax, and
- Owner’s equity.
Using our pizza shop example, imagine that we could increase net profit after tax to $100,000 and reduce owner’s equity to $300,000 (say by selling $50,000 of idle assets and borrowing $50,000 more from the bank). Return on equity will improve from 25% to 33%!
So we can increase net profit after tax or lower owner’s equity, and the return on equity will improve. Let’s look at some ways we can do this:
To increase net profit after tax we can:
- Increase revenue by lifting prices.
- Increase revenue by generating a higher sales volume.
- Reduce the cost of goods sold by finding ways to use less inputs, for example by reducing usage or improving processes.
- Reduce the cost of goods sold by reducing the prices paid for your inputs, for example by negotiating with suppliers for lower prices or discounts.
- Reduce expenses by finding ways to reduce sales and marketing expenses, utilizing employees more efficiently and looking into ways to reduce all other costs (e.g. insurance, rent, utilities, etc.)
- Reduce taxes
To reduce the owner’s equity you can:
- Reduce total assets by replacing expensive equipment with equally serviceable but cheaper alternatives, selling idle assets or participating in sale and leaseback opportunities.
- Optimize debt-to-equity ratio by refinancing existing loans more favorably, or increasing the use of debt to finance the business (only where it is advantageous based on terms, interest and repayments).
Always get advice on these matters. If you can reduce owner’s equity it means you can release funds from your business to invest in other opportunities, and generate a higher return on the remaining funds. A win-win if you manage it correctly.
For business owners, return on equity is a key metric to determine whether you're doing well or not. Put simply, if your return on equity is less than the amount you would earn by putting the money into safe investments, and it doesn’t look like that will change, you need to reconsider your investment.
On the other end of the spectrum, if you are earning a high and sustainable return on equity then you should look for ways to increase your investment in your core business or adjacent markets (e.g. new products or geographies).
Either way, you should continually monitor your return on equity, compare it to your industry benchmark, continually look for ways to improve it, and then have plans in place to sustain those improvements.
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