Return on Average Equity (ROAE)

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What is Return on Average Equity?

Return on Average Equity (ROAE) extends the ratio of Return on Equity. Instead of the total equity at the end of the period, it takes an average of the opening and the closing balance of equity for some time. It is calculated as Net earnings divided by Average total equity.

Here’s the formula –

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  1. The return on average equity ratio considers a company's opening and closing equity balances instead of the total balance. 
  2. One can calculate this by dividing the net income by the average shareholders' equity. Moreover, in the net income, interest expense is calculated. 
  3. The investors interpret the outcome in two ways: Higher ratio indicates appropriate utilization of the shareholders' equity, whereas a lower ratio indicates inefficiency in caring for the shareholders' equity.
  4. Companies should be mindful of their use of shareholders' equity and keep bad decisions at bay. 
return on average equity roae

Explanation

In this ROSE formula, there are two components.

The first component is net income.

  • We can find the net income in the income statement of the company. Net income is the last item on the income statement. We calculate the net income by deducting the operating expenses and other related and unrelated expenses from the company's operating revenue and other incomes.
  • However, since we are calculating the proportion only based on shareholders' equity, we shouldn't deduct interest expense in the net income.
  • Since we are not considering debt in this ratio, it doesn't make sense to include the cost of debt (interest expense) in the formula.
  • However, if the company is a whole-equity company (and there's no debt), we won't need to consider any such measure.

The second component of the formula is the average shareholders' equity.

  • Shareholders' equity is an important financial statement that we often include under the balance sheet.
  • We can consist of common shares, preferred shares, and dividends in shareholders' equity.
  • To find out the average of the shareholders' equity, we need to consider both the beginning figure of shareholders' equity and the ending figure of the shareholders' equity. Once we have the two figures, we will use the simple average to determine the average shareholders' equity.
  • However, we need to take a refined approach if there are more equity transactions during the period. Then it's better to use the weighted average method to find out the average.

Video Explanation of Return on Average Equity

 

Example of Return on Average Equity

Let's take practical examples.

Big Brothers Company has the following information for you –

  • Net Income for the year - $45,000
  • The beginning figure of shareholders’ equity - $135,000
  • The ending figure of shareholders’ equity - $165,000

Find out the return on average equity (ROAE) of Big Brothers Company.

First, we will calculate the average of shareholders' equity by simply adding the beginning and the ending figures and dividing the sum by 2.

Here’s the calculation –

  • Average shareholders’ equity = ($135,000 + $165,000) / 2 = $150,000.
  • Net income for the year is $45,000.

Using the ratio of ROAE, we get –

ROAE Formula = Net Income / Average Shareholders’ Equity = $45,000 / $150,000 = 30%.

RETURN ON EQUITY CALCULATION OF COLGATE

Below are the balance sheet details of Colgate from 2008 to 2015. You can download this sheet from Ratio Analysis Tutorial.

Colgate ROSE has remained healthy in the last 7-8 years. Between 2008 to 2013, Return on Equity was around 90%.

Colgate 2

In 2014, Return on Equity was at 126.4%, and in 2015, it jumped significantly to 327.2%.

Ratio Analysis Colgate

This has happened despite a 34% decrease in Net Income in 2015. Return on equity jumped significantly because of the decrease in Shareholder's Equity in 2015. Shareholder's equity decreased due to share buyback and accumulated losses that flow through the Shareholder's Equity.

How to Interpret this Ratio?

This ROAE ratio helps us understand how well shareholders' equity is used to generate net income. If an investor wants to invest in the common shares, she will get an idea about the efficiency of the company's shareholders' equity by using this ratio.

  • If the ratio is higher, it indicates that the shareholders' equity is properly utilized during the period to generate the net income.
  • If the ratio is lower, the management isn't efficient enough to manage and utilize the shareholders' equity.

Return on Average Equity Formula Calculator

You can use the following Calculator.

Calculate Return on Average Equity in Excel (with excel Template)

Let us now do the same example above in Excel.

This is very simple. You need to provide the two inputs of Net Income and Average Shareholder's Equity.

You can easily calculate the return on average equity in the template provided.

Return on Average Equity in excel

You can download this template here - Return on Average Equity Excel Template.

Return on Average Equity Video

 

Frequently Asked Questions (FAQs)

What is a good figure for return on average equity?

A considerable figure for return on average equity would be 15-20% which looks good to the investors and shareholders. Analysts use it to evaluate the fiscal performances of dissimilar companies in the same industry.

Which is better, high or low ROAE?

Return on equity or average equity refers to the return it generates from the net income and shareholders' equity. It is profitable if the return is higher since that indicates proper usage of the company's profit conversion.

What is the importance of return on equity?

Return on equity is an important metric to understand the management caliber and productivity of the business and comprehend how well the company takes charge of its equity against its net income.