Return on Equity

A financial ratio calculated as net income divided by owner equity, showing the return generated on capital invested by an organisation's owners.

Source: Brealey, Myers & Allen 2019

Return on equity is calculated by dividing net income by owner equity, expressing the profit earned on the funds that owners have committed rather than on total assets. Because equity is only the portion of assets not financed by debt, borrowing can raise the ratio even when underlying performance is unchanged. This is why it is read together with the organisation's level of borrowing. Zelman and colleagues (2020) explain how the ratio reflects returns to invested capital in health organisations.

Source: Zelman et al. 2020

Return on equity indicates how much profit an organisation generates from the capital its owners have invested, so a higher figure means a greater return on that capital. It reflects profitability and how the organisation is financed, since using debt as well as equity can raise the return earned on the equity portion. A low return signals that owners' capital is generating little surplus, which bears on the organisation's attractiveness to those who fund it.

Source: Brealey, Myers & Allen 2019

Return on equity is used by owners and investors to judge the return earned on their capital and to compare it with alternatives, and by managers to assess performance. It is applied mainly where organisations have owners with invested capital, such as private providers or insurers. In public health care, which has no equity owners in the usual sense, the measure is less applicable, so it is used chiefly in the private parts of the sector.

Source: Brealey, Myers & Allen 2019

Return on equity can be raised by using more debt rather than by better performance, since borrowing reduces the equity base against which profit is measured, so a high figure may reflect heavy borrowing and greater risk rather than efficiency. It depends on how profit and equity are measured, and can be distorted by one-off items or by a small equity base. It should therefore be read alongside measures of debt and of the return on assets.

Source: Brealey, Myers & Allen 2019

Return on equity is linked to financial risk through the use of debt: borrowing can raise the return on equity when things go well, because profit is measured against a smaller equity base, but it magnifies losses when they go badly, since the fixed obligations remain. A high return on equity driven by heavy borrowing therefore carries greater risk. Reading it alongside the debt ratio shows how much of the return reflects performance and how much reflects gearing.

Source: Brealey, Myers & Allen 2019