Financial Ratios Part 9 of 21: Rate of Return on Equity
Determining the rate of return on the owner’s equity in a business vs. other investments
Financial Ratios and indicators can assist in determining the health of a business. There is a minimum of 21 different ratios and indicators that can be looked at by many financial institutions. You cannot look at a single ratio and determine the overall health of a business or farming operation. Multiple ratios and indicators must be used along with other information to determine the total and overall health of a farming operation and business. This series of articles will look at 21 commonly used ratios and indicators.
Rate of Return on Equity is a measure of Profitability and is determined based on information derived from a business’ or farm operations Income Statement. The term Profitability is the difference between the value of what is produced or service provided and the cost of producing that product or providing that service. The Rate of Return on Equity specifically provides the percentage of interest that has been earned on the investments into the business by its owner and should be compared with the possible interest that could have been earned if the money was invested elsewhere.
The following equation will determine your Rate of Return on Equity:
Rate of Return on Equity = Return on Equity/Average Farm Net Worth
Return on Equity = Net Income – Value of operator unpaid labor and management (a dollar amount will have to be given to the value of the operator’s unpaid labor and management, this should be equal to what it would take to hire someone to do the equivalent work in labor and management)
Rate of return on equity is measured as a percentage. This is one of those measures that is easy to understand, the larger the number the better the return on the owners investments (Owners equity) into the business. The one question that must be answered by the owner when looking at this number is whether this return is worth the investment of labor, management, and equity compared to other sources of investment.
If you have any further question please feel free to contact your local Farm Management Educator or the author.
Information for this article has been gathered using material created by the University of Minnesota Center for Farm Financial Management (CFFM)
You can read the other articles in this series:
Part 1: The current ratio
Part 2: Working capital.
Part 3: Working capital to gross revenues
Part 4: Debt-to-asset ratio
Part 5: Equity-to-asset ratio
Part 6: Debt-to-equity ratio
Part 7: Net farm income
Part 8: Rate of return on assets
Part 10: Operating profit margin
Part 11: The EBITDA measurement of profitability
Part 12: Operating profit margin
Part 13: Capital debt repayment margin
Part 14: Replacement margin
Part 15: Term debt coverage
Part 16: Replacement margin coverage ratio
Part 17: Asset turnover rate
Part 18: Operating-expense ratio
Part 19: Depreciation-expense ratio
Part 20: Interest-expense ratio
Part 21: Net income ratio