What is Return on Average Equity?
Return on Average Equity (ROAE) is an extension of the ratio Return on Equity and 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 a period of time and is calculated as Net earnings divided by Average total equity.
Here’s the formula –
In this ROAE 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 operating revenue and other incomes of the company.
- However, here since we are calculating the proportion only on the basis of shareholders’ equity, we shouldn’t deduct interest expense in the net income here.
- Since we are not taking debt into account 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), then 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 which we often include under the balance sheet.
- In shareholders’ equity, we can include common shares, preferred shares, and dividends.
- To find out the average of the shareholders’ equity, we need to consider both the beginning figure of shareholders’ equity and also the ending figure of the shareholders’ equity. Once we have the two figures, we will just use the simple average to find out 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 average.
Example of Return on Average Equity
Let’s take a 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.
Here first, we will calculate the average of shareholders’ equity by simply adding the beginning and the ending figures and then 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%.
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RETURN ON EQUITY CALCULATION OF COLGATE
Below is a balance sheet details of Colgate from 2008 to 2015. You can download this sheet from Ratio Analysis Tutorial.
Colgate ROAE has remained healthy in the last 7-8 years. Between 2008 to 2013, Return on Equity was around 90% on average.
In 2014, Return on Equity was at 126.4%, and in 2015, it jumped significantly to 327.2%.
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 also because of 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 would get an idea about the efficiency of the shareholders’ equity of the company 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, it indicates that 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.
|Return on Average Equity Formula =||
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 Shareholders Equity.
You can easily calculate the return on average equity in the template provided.
You can download this template here – Return on Average Equity Excel Template.
Return on Average Equity Video
This has been a guide to Return on Average Equity and its meaning. Here we discuss the formula to calculate Return on Average Equity along with practical examples and its interpretation. Here we also provide you with ROAE Calculator with a downloadable excel template.