return on equity
/ R-O-E /
Suppose you put 100,000 of your own money into a business and at year-end it earned you 15,000 in profit. Your money grew by 15% — that is the return on what you, the owner, actually put in. Return on equity asks this from the owners' point of view: for every dollar the shareholders have invested, how much profit did the company earn for them?
Return on equity, or ROE, equals net income divided by owners' (or shareholders') equity, as a percentage. (As with ROA, average equity is often used.) If a company earns 80,000 of net income on 400,000 of equity, its ROE is 80,000 / 400,000 = 20%. Unlike return on assets, ROE looks only at the owners' slice, so borrowing affects it: a company can lift its ROE by financing more of its assets with debt instead of equity, because the same profit is then spread over a smaller equity base. That is why ROE typically sits above ROA whenever a firm uses debt.
Return on equity matters because it is the headline measure of how well a company rewards its owners, and a favorite of stock investors. But its sensitivity to leverage is a double-edged sword: a high ROE may reflect genuinely excellent operations, or simply a lot of risky debt magnifying a mediocre return. The DuPont framework exists largely to pull these apart, splitting ROE into profitability, efficiency, and leverage. The caveat: a sky-high ROE driven by heavy borrowing is fragile — the very leverage that lifts it in good years can wipe out equity in bad ones.
Two firms each earn 100,000. Firm A funds itself with 1,000,000 of equity (ROE 10%); firm B uses 500,000 equity plus 500,000 debt (ROE 20%). B's higher ROE comes from leverage, not better operations — and that same debt makes it riskier.
Leverage can double ROE without improving the underlying business.
A high ROE may signal great operations or merely heavy debt; always check leverage before celebrating it, since borrowing inflates ROE while raising risk.