The formula
The return on equity is the business’s answer to one question: how much profit does each dollar of equity produce. Take the net income — profit after all costs — and divide it by the shareholders’ equity — what the owners put in plus the profits the business kept. A return of 20.00% means each dollar of equity earns 20 cents. This guide works it in seven steps.
Step 1 — Find the net income
Start with the net income: the profit after all costs, the bottom line of the income statement. Use the same period for everything — a year, a quarter, a month. On the worked example the net income is $250,000.00.
Step 2 — Find the shareholders’ equity
Now find the shareholders’ equity: what the owners put in plus the profits the business kept, from the balance sheet. It is the assets minus the debts. Use the same period as the net income. On the worked example the shareholders’ equity is $1,250,000.00.
Step 3 — Divide the net income by the shareholders’ equity
Divide the net income by the shareholders’ equity. That is the return as a fraction. On the worked example it is $250,000.00 ÷ $1,250,000.00 = 0.20. Each dollar of equity earns 20 cents of profit.
Step 4 — Multiply by 100
Multiply by 100 to turn the fraction into a percent. On the worked example it is 0.20 × 100 = 20.00%. The return on equity is 20.00% — the business earns 20 cents on every dollar of equity its owners put in.
Step 5 — Work out the equity the target needs
Divide the net income by the target to find the equity the target needs. On the worked example the target is 25.00%, so the equity needed is $250,000.00 ÷ 0.25 = $1,000,000.00. The largest whole-dollar equity for the return to stay at or above 25.00% is $1,000,000 — at $1,000,001 the equity is $1 over the $1,000,000 allowed.
Step 6 — Work out the net income the target needs
Multiply the shareholders’ equity by the target to find the net income the target needs. On the worked example it is $1,250,000.00 × 0.25 = $312,500.00. The smallest whole-dollar net income for the return to reach 25.00% is $312,500 — at $312,499 the net income is $1 short of the $312,500 needed.
Step 7 — Check the result against the 20% strong line and the 10% thin line
Compare the return with the lines: above 20% is strong, 10–20% is typical, below 10% is weak and means the owners’ money is not pulling its weight. On the worked example the return is 20.00%, so the business sits on the strong line. Below 0% the business lost money — with net income of −$125,000.00 and equity of $1,250,000.00 the return is −10.00%.
Three worked examples
The headline example: $250,000.00 of net income and $1,250,000.00 of shareholders’ equity. The return is $250,000.00 ÷ $1,250,000.00 = 20.00%, the equity needed for the 25.00% target is $1,000,000.00, and the net income needed for the 25.00% target is $312,500.00. Net income of $500,000.00 instead: the return is 40.00%. Equity of $2,500,000.00 instead: the return is 10.00%. Use the return on equity calculator for your own numbers.
Two reverses to check your answer
The largest whole-dollar equity for the return to stay at or above 25.00% is $1,000,000 — at $1,000,000 the return is 25.00%, and at $1,000,001 the equity is $1 over the $1,000,000 allowed. The smallest whole-dollar net income for the return to reach 25.00% is $312,500 — at $312,500 the return is 25.00%, and at $312,499 the net income is $1 short of the $312,500 needed.
What net income and shareholders’ equity are, and what they are not
Net income is profit after all costs: revenue minus every expense, including interest and tax. Shareholders’ equity is what the owners put in plus the profits the business kept: the assets minus the debts. What they are not: net income is not the cash flow, and shareholders’ equity is not the total assets — the equity is the assets minus the debts. A business can report strong net income and still be short of cash, because net income counts sales it has not yet collected.
Why a return above 20% is strong
A return above 20% is strong because equity is the owners’ money at risk: a bad year, a broken machine, a customer who does not pay, and the return falls. At 20.00% the business earns 20 cents on every dollar of equity; at 10.00% it earns only 10 cents, and the owners’ money is barely pulling its weight. Below 10% the business has little room for a bad year, and a single breakdown can push it under.
What to do below target
A return below target means the equity earns less profit than the target allows. If the return were 10.00% instead, the business would be at the bottom of the typical band. The fixes are the formula’s two levers: raise the net income, or cut the shareholders’ equity. Raise prices, cut costs, or pay out the equity that earns nothing. The largest whole-dollar equity that stays at or above 25.00% is $1,000,000 — at $1,000,001 the equity is $1 over the $1,000,000 allowed.
What a very high return means
A return above 25.00% does not mean five times as safe — it may mean the business is asset-light, like a software company that needs little equity, or it may mean the business borrowed a lot, so a small equity base makes the return look big while the risk is real, or it may mean the business is running its equity hard with little slack for a breakdown or a bad year. On $250,000.00 of equity and $250,000.00 of net income the return is 100.00% and the equity needed for a 25.00% return is $1,000,000.00. The 25.00% line is the line for making the equity work; above it, the question is whether the business should borrow more to grow faster — and whether it can afford the risk.
How the return on equity differs from return on assets, profit margin and the operating margin
Return on assets divides by total assets, not shareholders’ equity: it asks how much profit each dollar of assets produces, so debt does NOT inflate it, because the assets are bigger than the equity. Profit margin divides by revenue, not equity: it asks how much of each sales dollar survives as profit. The operating margin tests operating income against revenue. Return on equity is the equity test; return on assets is the asset test; the operating margin is the operating test; the interest coverage ratio is the earnings test against what the business owes its lenders.