ROE – Return on Equity is an important financial ratio. ROE measures how much profit is generated from the equity invested in a company. It is expressed as a percentage.
ROE – Return on Equity: Definition and Formula
The primary goal of any company is (or should be) profit maximization. An owner who invests money or other assets in the business naturally expects a return on this invested capital. The higher the ROE, the more profit each unit of equity generates.1
A high ROE generally indicates that equity is being used efficiently to generate profits. However, this is not always the case. For example, an extremely leveraged company with low equity may report high ROE if it generates profit, but such a company is highly exposed to economic cycles and interest rate fluctuations.2
In a low interest rate environment, such a company may generate profits easily. If interest rates rise, financial risks increase. ROE alone does not reflect this risk, so it should be interpreted carefully, in context with other financial ratios. Ideally, it should also be analyzed using the DuPont decomposition, which highlights the impact of leverage and other factors on equity profitability.
ROE is calculated as net profit divided by equity. This is a relatively straightforward calculation. The denominator is the equity value from the financial statements, typically using an average if monthly data are available. The numerator (profit) can vary depending on the approach, as discussed below.
Profit Measure in ROE – EAT, EBIT, or EBT?
In the general ROE formula, the numerator is profit, but profit can take multiple forms: EBIT, EBITDA, EBT, EAT, etc. Different sources may use different profit measures, often without explaining why one method was chosen over another.
Which profit should be used? It depends on the situation, the company, the industry, the balance sheet structure, and what the analyst aims to measure. The choice of profit measure can significantly affect ROE and should be considered in interpretation. Net profit after taxes (EAT) is the most commonly used measure. However, if we want a broader view of ROE, other approaches may be relevant:3
- International sources most often use net profit (EAT – earnings after taxes), which reflects equity profitability for owners and shareholders.
- Alternatively, profit can be measured as EBIT (earnings before interest and taxes) or even EBITDA, excluding interest and taxes, to evaluate profitability for stakeholders beyond owners, such as creditors or the state. This approach is particularly useful when the company wants to measure operational profitability independently of financial costs.
- Capital structure (financial leverage) can significantly influence ROE, because debt indirectly contributes to profit. A DuPont decomposition can help separate these effects and better understand ROE components.
Examples of Using Different Profit Measures for ROE – Interpretative Scenarios
Example 1: A manufacturing company financed with debt to purchase a machine generating operating profit.
If we use EBIT in the ROE formula, we measure profitability for owners, creditors, and the state, abstracting from interest and taxes. The debt financing indirectly increases profit, so ROE may appear higher. This does not distort the broader analysis, but it highlights how leverage contributes to equity profitability, which can be further analyzed using DuPont decomposition.
Example 2: A profitable marketing agency that has accumulated profits in financial products (time deposits, ETFs, or loans).
Using EBIT as profit does not distort methodology here. Interest income unrelated to core business operations is excluded from ROE. Alternatively, EAT or EBT can be used if one wants these financial profits to be included.
Example 3: When comparing ROE across companies with different tax regimes, using EBT or EBIT instead of EAT avoids distortions caused by tax differences.
Reference
- Investopedia, Return on Equity [online]. [cit. 2025-10-29]. Available at: https://www.investopedia.com/terms/r/returnonequity.asp
- Corporate Finance Institute, Return on Equity (ROE) [online]. [cit. 2025-10-29]. Available at: https://corporatefinanceinstitute.com/resources/accounting/what-is-return-on-equity-roe/
- Tipalti, Return on Equity [online]. [cit. 2025-10-29]. Available at: https://tipalti.com/en-eu/return-on-equity/