How is the return on equity (ROE) calculated?



Q17. Return on equity (ROE)
How is the return on equity (ROE) calculated?

A17.
(1) Return on equity (ROE)
= Net income / Average stockholders’ equity

(2) Average stockholders’ equity
= (Beginning stockholders’ equity + Ending stockholders’ equity) / 2

[Entity 17-a]
Net income = $42,000
Beginning stockholders’ equity = $350,000
Ending stockholders’ equity = $450,000
Average stockholders’ equity
= ($350,000 + $450,000) / 2
= $400,000
Return on equity (ROE)
= $42,000 / $400,000 = 10.5%

[Entity 17-b]
Net income = $51,000
Beginning stockholders’ equity = $470,000
Ending stockholders’ equity = $530,000
Average stockholders’ equity
= ($470,000 + $530,000) / 2
= $500,000
Return on equity (ROE)
= $51,000 / $500,000 = 10.2%

[Note]
Higher return on equity (ROE) –> more profitable.
Thus in this example, Entity 17-a is more profitable than Entity 17-b.

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