Q:

How do you calculate return on equity?

A:

Quick Answer

Return on equity is computed by divided a company's annual net income by the average value of stockholders' equity for the year, according to Accounting Explained. Therefore, annual net income of $50,000 divided by average equity of $1 million equals a 5 percent return on equity.

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Full Answer

Annual net income is recorded on a company's annual accounting statement. Shareholders' equity is recorded on a company's balance sheet. To determine the annual average, a person would add equity from the end-of-year balance sheet for two years in a row and divide by two, according to Accounting Explained. If equity was $750,000 at the start of the current year and $1.25 million at the end, average equity is $2 million divided by two, or $1 million.

The value of shareholder's equity depicted on a balance sheet is a combination of paid-in capital, retained earnings, common stock and preferred stock, according to About.com. This equity value is also known as the net worth of the company. Shareholders typically perceive return on equity as the most important measure of profitability, according to About.com. To say a business has a 25 percent return on equity means that 25 cents in profit was generated for every $1 of equity.

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