How to Calculate Return on Equity from a Balance Sheet

Calculating Return on Equity (ROE) shows you exactly how well a company is using shareholder funds to generate profit. It's one of the most direct measures of a company's profitability and financial performance. This article will walk you through finding the necessary numbers on your financial statements, applying the formula step-by-step, and interpreting what the final result tells you about a business's health.

What is Return on Equity (ROE)?

Return on Equity is a financial ratio that measures a company's profitability by revealing how much profit it generates with the money shareholders have invested. In simple terms, it answers the question: "For every dollar of equity shareholders own, how many cents of profit did the company create?" A higher ROE generally indicates that a company's management is more efficient at using its equity base to generate profits.

Investors and analysts use ROE to compare the profitability of companies within the same industry. If a company has a consistently rising ROE, it often signals that it's getting better at generating profit without needing as much capital. For business owners and internal finance teams, tracking ROE provides a clear performance benchmark for how effectively shareholder capital is being reinvested into the business.

The ROE Formula and Its Components

The standard formula for calculating ROE is straightforward:

ROE = Net Income / Average Shareholder’s Equity

Let's break down each piece of that equation.

• Net Income: This is the classic "bottom line." It represents a company's profit after all expenses, including operating costs, interest, and taxes, have been paid. You will find this number at the very bottom of the Income Statement for a specific period (e.g., a quarter or a year).
• Shareholder's Equity: Often called "book value," this is the amount of money that would be returned to shareholders if all the company's assets were liquidated and all of its debts were paid off. Its accounting formula is simple: Total Assets – Total Liabilities. You find it on the company’s Balance Sheet.
• Average Shareholder's Equity: ROE is most accurate when you use average equity over the period. Net income is generated over an entire year, but the balance sheet's equity figure is a snapshot from a single day. Using an average helps smooth out timing discrepancies, especially if the company issued or repurchased stock during the year. The formula for the average is: (Beginning Shareholder’s Equity + Ending Shareholder’s Equity) / 2.

A Step-by-Step Guide to Calculating ROE from Financial Statements

Theory is useful, but the best way to understand ROE is to calculate it with real data. Let's walk through an example using a fictional business, "Evergreen Office Solutions," to see how the numbers flow from the financial statements into the final ratio.

First, we need three pieces of data:

1. Net Income for the current period.
2. Total Shareholder's Equity from the end of the current period.
3. Total Shareholder's Equity from the end of the prior period (which serves as the beginning equity for the current period).

Step 1: Find Net Income on the Income Statement

Your first stop is the Income Statement for the period you want to analyze. We'll be looking at the full year of 2023. You'll find Net Income, sometimes called "Net Earnings," at the bottom of the statement after all revenues and expenses have been accounted for.

Let's look at Evergreen Office Solutions' simplified Income Statement for the year ended December 31, 2023:

(Simplified Income Statement Excerpt)

• Revenue: $2,500,000
• [...]
• Earnings Before Tax: $210,000
• Taxes: $42,000
• Net Income: $168,000

We have our first number: Net Income = $168,000.

Step 2: Locate Shareholder’s Equity on the Balance Sheets

Next, we need two Balance Sheets: one for the end of the current period (December 31, 2023) and one for the end of the prior period (December 31, 2022). The Shareholder’s Equity section is typically at the bottom of the "Liabilities & Equity" side of the balance sheet.

Here are the relevant excerpts for Evergreen Office Solutions:

Balance Sheet as of December 31, 2023:

• [...]
• Total Liabilities: $600,000
• Total Shareholder’s Equity: $950,000

This gives us our Ending Equity: $950,000.

Balance Sheet as of December 31, 2022:

• [...]
• Total Liabilities: $550,000
• Total Shareholder’s Equity: $850,000

This gives us our Beginning Equity: $850,000.

Step 3: Calculate the Average Shareholder's Equity

Now we use the beginning and ending equity figures to find the average for the year.

• Formula: (Beginning Equity + Ending Equity) / 2
• Calculation: ($850,000 + $950,000) / 2 = $1,800,000 / 2 = $900,000

Our Average Shareholder’s Equity for 2023 is $900,000.

Step 4: Put It All Together to Calculate ROE

With Net Income and Average Equity, we have everything we need to calculate the Return on Equity.

• Formula: ROE = Net Income / Average Shareholder’s Equity
• Calculation: $168,000 / $900,000 = 0.1867

To express this as a percentage, multiply by 100:

Evergreen’s ROE = 18.7%

This result means that for every dollar of shareholder equity in the business, Evergreen generated 18.7 cents in profit during 2023. You can now use this figure to compare against Evergreen's previous years or against its direct competitors.

Going Deeper: Understanding the Drivers with DuPont Analysis

A ROE of 18.7% is informative, but it doesn’t tell you the whole story. Is this a result of high profit margins, efficient use of assets, or heavy use of debt? The DuPont analysis, developed by the DuPont Corporation in the 1920s, disassembles the ROE formula into three key components to give you a clearer picture.

The DuPont formula is: ROE = (Net Profit Margin) x (Asset Turnover) x (Financial Leverage)

Let’s look at each part:

1. Net Profit Margin = Net Income / Revenue
   This ratio measures how much profit the company makes per dollar of sales. It’s a pure profitability gauge. For Evergreen: $168,000 / $2,500,000 = 6.72%.
2. Asset Turnover = Revenue / Average Total Assets
   This measures how efficiently the company uses its assets to generate revenue. A higher number indicates greater efficiency. We'll need Evergreen's average assets: Let's assume Beginning Assets were $1,400,000 and Ending Assets were $1,550,000, for an average of $1,475,000. For Evergreen: $2,500,000 / $1,475,000 = 1.695.
3. Financial Leverage = Average Total Assets / Average Shareholder’s Equity
   This ratio indicates how much of the company's asset base is financed through debt versus equity. A higher number signals more debt. For Evergreen: $1,475,000 / $900,000 = 1.639.

Now, let's multiply them together:

0.0672 (Margin) x 1.695 (Turnover) x 1.639 (Leverage) = 0.1867, or 18.7%

The result matches our original calculation. But now we have much more insight. We see that Evergreen's ROE is a balanced combination of modest profit margins, solid asset efficiency, and a moderate amount of debt. If ROE were to change in the future, you could use this decomposition to identify exactly which part of the business model was responsible.

Important Considerations When Interpreting ROE

ROE is a powerful metric, but it should never be analyzed in a vacuum. Keep these points in mind for proper context:

• Debt Can Skew Results: A company can boost its ROE by taking on more debt. Because leverage increases the ROE calculation (as seen in the DuPont analysis), a very high ROE might hide significant financial risk. Always look at the company's debt-to-equity ratio alongside ROE.
• Industry Matters Greatly: What constitutes a "good" ROE varies enormously by industry. Tech companies with few physical assets may have high ROEs, while capital-intensive businesses like utilities or manufacturing will naturally have lower ROEs. Always compare a company's ROE to its direct industry competitors.
• Negative Values are Ambiguous: If a company has a net loss, its ROE will be negative, making it hard to interpret directly. Likewise, if shareholder's equity is negative (a sign of severe financial distress), the ROE calculation becomes mathematically useless. A consistent history of positive ROE is far more important than a single period's figure.

Final Thoughts

Calculating Return on Equity from a balance sheet and income statement is a fundamental skill for financial analysis. By pulling net income and average shareholder's equity, you can quickly gauge how effectively a business turns owner investments into profits. Taking the extra step to break it down with a DuPont analysis provides a much clearer story of a company’s operational efficiency, profitability, and financial structure.

Of course, calculating a key ratio like ROE is just the beginning. The real work comes when clients ask how to improve it, raising deeper questions about tax strategy, debt financing, or even the benefits of structuring equity as Qualified Small Business Stock. For those complex scenarios, where definitive answers require chasing down IRC sections and revenue procedures, wading through dense government websites isn't a good use of time. Instead, we use tools like Feather AI to get clear, citation-backed answers on tax matters in seconds, freeing us up to focus on the strategic guidance that helps clients move the needle.