The return on equity (abbreviated: EKR) is one of the most important key figures, especially for investors and all those who hold shares in the company. We therefore take a closer look at what information is worth knowing about the return on equity and how it should be interpreted.
Return on Equity Definition
The return on equity indicates the return on the capital employed . It results from the ratio of profit and equity and is usually given in percent. As a profitability metric, it is often viewed along with other metrics, such as return on investment.
Interpretation of return on equity
The profitability should of course always be as high as possible . The equity capital employed is the capital that carries the greatest risk. This is why this form of capital is the most expensive. So if you provide equity, you also expect a good return on the capital invested in line with the high risk. The minimum level of a good return on equity is that this return is higher than that on the long-term capital market.
The leverage effect, which we will go into in more detail below, is also of great importance in this context.
Put simply, this means that investors have to achieve a better return by investing in equity in a company than on the other, long-term capital market, i.e. if they were to make alternative investments.
Meaning of the ratio of return on equity
The key figure is of great importance because it is particularly important for investors. The cash flow is, for example, the company itself is of utmost relevance. The incoming and outgoing payments show whether there is always operational liquidity . From the investor’s point of view, however, the focus is on what rate of return they get on the capital invested. This value is obtained when the profit is set in relation to equity.
As always with key figures, different key figures have to be considered in order to get an overall picture of the company. In the case of return on equity, it is the decisive indicator for recognizing the return on the chapter.
Start-ups are in a special situation here. You may not be making a profit yet, which also makes the calculation of the return on equity ad absurdum. Instead, other key figures can be used instead, such as the burn rate, i.e. the amount of capital that is consumed per month for the ongoing operation of the company.
Calculation of return on equity – formula
Calculating the return on equity is simple. You only need the equity invested and the profit as an absolute number. The annual surplus is divided by the equity and multiplied by 100 to obtain a result in percent.
Return on Equity Formula:
Return on Equity (EKR) = Profit (Net Income) / Equity x 100
The amount of equity is shown in the balance sheet . The profit is taken from the profit and loss account and is typically the annual surplus after taxes. Alternatively, the EBIT , i.e. the earnings before interest and taxes, could also be used for calculation. However, this variant is less common. Interest and taxes have not yet been deducted here, meaning that significant interest effects can be taken into account.
Special case of sole proprietorship
If the return on equity is calculated in a sole proprietorship and the business owner does not pay himself a wage, but lives on the annual surplus, an imputed entrepreneur’s wage is to be applied. This is a fictitious value that reduces the annual surplus as if the entrepreneur were getting a salary himself. The effect is that an annual surplus is then used in the calculation, which takes into account that the entrepreneur himself brings in work that would have to be paid for if it were carried out by other people.
Example: return on equity and imputed entrepreneur wages
For example, if a company generates an annual surplus of EUR 100,000 and equity is EUR 1,000,000, then 100,000 / 1,000,000 x 100 results in a return on equity (EKR) of 10% for this year.
If the company were a sole proprietorship in which the entrepreneur did not pay himself any wages, then in the calculation, for example, € 60,000 per year could already be deducted from the annual surplus as a fictitious entrepreneur’s wage before division.
Target values for return on equity
There is no specific target for an ideal return on equity. Basically, it can be said that the return should be higher than that of long-term investments on the other capital market for long-term investments, for example when looking at long-term bonds or global ETFs . We are therefore now going into more detail on how different returns are to be understood.
Typically, the return on equity should be over 10 percent , but values over 20 percent are very rare – and should be scrutinized. We’ll explain why exactly now.