Return on equity

Return on equity (ROE) is profit after interest and tax divided by total equity, and shows the return the business earns on the shareholders’ own money. Borrowing changes it sharply: when the business earns more on its assets than its debt costs, gearing pushes ROE up, and when it earns less, gearing pushes ROE down, so a high ROE can signal either strong performance or high financial risk.

How is return on equity calculated?

ACCA’s ratio analysis article gives the formula as:

ROE = profit after interest and tax ÷ total equity × 100%

It explains that if you want the return on ordinary shareholders’ funds, you use profit after interest and tax divided by total equity, in contrast to return on capital employed, which uses profit before interest and tax against debt plus equity. Total equity is share capital, share premium, retained earnings and other reserves, as shown in the statement of changes in equity.

Two refinements make the figure more meaningful:

• Average equity. Profit is earned over the year, so dividing by the average of opening and closing equity is usually fairer than the closing figure, especially if shares were issued or bought back.
• Preference shares. If some preference shares are presented as equity, deduct their dividends from profit and their capital from equity to get the return to ordinary shareholders. Whether they are equity or a liability is covered in preference shares as debt or equity.

What does ROE tell shareholders?

ACCA says a return on capital is needed to reward investors for the risks they take, that generally the higher the ROE the better for investors, and that it should be compared with returns available on alternative investments of similar risk. For an owner managed company, ROE answers a simple question: is the money left in the business earning more than it could earn elsewhere at the same risk?

ROE can be split into three parts: net profit margin (profit after tax ÷ revenue), asset turnover (revenue ÷ total assets) and an equity multiplier (total assets ÷ equity). Multiply them and revenue and total assets cancel out, leaving profit after tax ÷ equity. The first two describe trading performance. The third is pure financing: the more of the assets funded by debt, the bigger the multiplier.

How does gearing distort ROE?

ACCA notes that borrowed capital is attractive because lenders accept a lower return than equity investors given their secured position, and because interest is tax deductible while dividends are not. If the business earns more on borrowed money than the interest it pays, the surplus goes to shareholders and ROE rises. The cost is risk: ACCA also points out that interest and capital repayments are legal obligations, whereas dividends are not.

Illustration only. Two companies each have capital employed of £4,000,000 and the same operations. Company X is funded entirely by equity. Company Y has equity of £1,600,000 and loans of £2,400,000 at 6%. Tax is taken at a flat 25% for simplicity; in practice marginal relief applies to profits between £50,000 and £250,000.

	X: good year	Y: good year	X: poor year	Y: poor year
Operating profit (PBIT)	£600,000	£600,000	£200,000	£200,000
ROCE	15%	15%	5%	5%
Interest at 6%	nil	£144,000	nil	£144,000
Profit before tax	£600,000	£456,000	£200,000	£56,000
Tax at 25%	£150,000	£114,000	£50,000	£14,000
Profit after tax	£450,000	£342,000	£150,000	£42,000
Equity	£4,000,000	£1,600,000	£4,000,000	£1,600,000
ROE	11.3%	21.4%	3.8%	2.6%

In the good year Y’s ROE is almost double X’s, though the businesses perform identically. In the poor year ROCE of 5% is below the 6% interest rate, and Y’s shareholders do worse than X’s. If operating profit fell to £100,000, X would still make a small profit while Y would make a loss before tax of £44,000. The higher ROE in the good year was paid for with this extra volatility, which is why ROE should always be read with the gearing ratio and interest cover.

What else can make ROE misleading?

• Small or negative equity. A company with accumulated losses can have tiny or negative equity, giving a huge or meaningless ROE.
• Share buybacks. A company share buyback reduces equity, so ROE rises even if profit is unchanged.
• Revaluations. ACCA’s performance appraisal article notes that revaluing non current assets increases capital employed without any real change in operating capacity or profitability. Any revaluation surplus sits in equity, so the same effect lowers ROE.
• Retained profits. A profitable company that pays no dividends builds up equity year after year, so ROE drifts down even if profit is steady.
• Tax rate differences. GOV.UK states the main rate of corporation tax as 25% for profits over £250,000 and the small profits rate as 19% for profits of £50,000 or less. Comparing ROE across companies of different sizes partly compares tax rates.
• Owner pay. Directors who take dividends rather than salary leave higher profit after tax in the company. See salary versus dividends.

How should you use ROE when comparing companies?

Use ROE for the shareholder’s question and ROCE for the operating question. A sensible order is:

1. Calculate ROCE to see how well each business uses its total funding.
2. Calculate ROE to see what shareholders actually earn.
3. If ROE is well above ROCE after tax, gearing explains the gap; check gearing and interest cover to judge whether the risk is acceptable.
4. Check equity for distortions such as buybacks, revaluations and accumulated losses.
5. Compare against a return on an alternative investment of similar risk, as ACCA suggests.

What are the common mistakes?

• Using profit before tax on top and equity below; the standard ROE uses profit after interest and tax.
• Treating a rising ROE as an improvement without checking whether it came from new borrowing.
• Comparing companies with very different equity histories, for example one with large retained reserves and one recently recapitalised.
• Ignoring equity classified differently under accounting standards, such as preference shares presented as equity.

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Related Accountapedia entries

• DuPont analysis of return on equity
• Asset turnover ratio
• Dividend cover
• Net profit margin
• Weighted average cost of capital (WACC)
• The equity method under IAS 28
• Accounting for a debt for equity swap
• Debt for equity swaps: tax for the company
• Is equity release money taxable

Sources

• ACCA: Ratio analysis
• ACCA: Performance appraisal
• GOV.UK: Corporation tax rates

Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 8 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.