Return On Average Equity Formula (Table of Contents)
- Return On Average Equity Formula
- Return On Average Equity Calculator
- Return On Average Equity Formula in Excel (With Excel Template)
Return On Average Equity Formula
Return on average equity is calculated to determine the performance of an entity. It is calculated by dividing Net Income by Average Shareholder’s Equity where “Net Income” means Net Profit distributable to equity shareholders i.e. after deducting all the expenses and payment to loans, debentures and preference shares and “Average Shareholders Equity” means average of shareholders’ funds or owner’s money invested to do business in last two years.
In general industry practice, Return on Equity is used more prominently than Return on Average Equity. However, Return on Average Equity provides a better understanding of a company’s performance especially in a scenario of changing equity.
Examples of Return On Average Equity Formula
XYZ Company has provided following information to calculate ROAE
- Net Income for the year = Rs. 25,000
- Shareholder’s Equity of previous year = Rs. 1,00,000
- Shareholder’s Equity of current year = Rs. 2,00,000
Let’s first calculate Average Shareholder’s Equity
- Average Shareholder’s Equity = (Shareholder’s Equity of previous year+ Shareholder’s Equity of current year)/2
- Average Shareholder’s Equity = (1,00,000+2,00,000)/2
- Average Shareholder’s Equity = 1,50,000
Now, let’s calculate ROAE for XYZ Company,
- ROAE = Net Income / Average Shareholder’s Equity
- ROAE = 25,000/1,50,000
- ROAE = 0.1667 or 16.67%
Explanation of Return On Average Equity Formula
Return on Average Equity Formula helps us to understand how much return an entity generates for its shareholders. In simple words, it helps us calculate that how much profit does an equity shareholder makes by investing in the entity or how much money has an equity shareholder made for every rupee invested by him/her in the entity. Now, whether the return generated by the entity are adequate or not would differ from investor to investor based on riskiness in an investment and other alternatives of investment. For e.g. If an investor can earn a return of 7%-8% by keeping its money in Bank Fixed Deposits which is comparatively less risky in terms of return on investment than investment in equity of an entity, then expectation of an investor from equity investment will definitely be higher than 7%-8% and would continue to increase with higher risk investments.
Also, as equity holders are the last persons to be paid by entities after paying all the expenses and debt repayments, risk of investment of equity investor is higher than others in the entity and so does its expectation of higher return compared to debt and preference shares.
However, it is not necessary that the profits available for distribution to the shareholders are actually distributed. Entities may choose to distribute a part of the profit and retain the rest for future growth.
Now, as illustrated in the example above, return on average equity is calculated by dividing Net Income of previous year with average equity of past 2 years, where Net Income means the Profit after tax which is available for distribution to the Equity Shareholder and equity means amount invested by equity shareholders.
Significance and Use of Return on Average Equity Formula
There is significant relevance and use of the Return on Average Equity formula for an investor who is evaluating to invest in equity shares of a company, as by using this formula, he/she understands what kind of returns he/she can expect from the company if they choose to invest and then compare it with other alternative investments and returns to make the best choice. If the investors, feels it to be a risky investment, he/she may expect a higher return on their investment and hence they could check using this formula that whether the company has ever given the kind of return he is expecting and accordingly form his/her decision to invest.
Return on Average Equity formula discloses that how efficiently an entity is managing shareholder’s money. If the ratio is on the higher side, it would mean that the entity is efficiently managing shareholder’s money and if the ratio is on the lower side then it is an indication of inefficient management of shareholders money y the management of the entity.
Return On Average Equity Formula Calculator
You can use the following Return On Average Equity Formula Calculator
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Return On Average Equity Formula in Excel (With Excel Template)
Here we will do the same example of the Return On Average Equity Formula in Excel. It is very easy and simple. You need to provide the two inputs Average Shareholder’s Equity and Net Income
You can easily calculate the Return On Average Equity Formula in the template provided.
As illustrated in the spreadsheet, there is a company named VU, whose Balance Sheet and Profit and Loss Account extract are given, and we have to calculate return on average equity. So, as per the formula we first calculated Net Income which is nothing but Profit after tax, and in order to do so, we subtract all the expenses including Interest and depreciation from Net Sales and arrive at Profit Before tax, then we deduct tax and arrive at Profit After Tax. Similarly, in the Balance Sheet, we have been provided with two years’ shareholder’s equity amount.
First, we calculate Average Shareholder’s Equity
then we calculate Return On Average Equity using Formula
This has been a guide to Average Equity Formula, here we discuss its uses along with practical examples. We also provide you with Average Equity calculator along with downloadable excel template.