To illustrate, let’s assume that a corporation's net income after tax was $100,000 for the most recent year. Let’s also assume that it did not have any preferred stock outstanding and that its stockholders’ equity was $950,000 at the beginning of the year and was $1,050,000 at the end of the year. The increase was at a uniform rate throughout the year. The return on stockholders’ equity will be 10% ($100,000 divided by the average stockholders’ equity of $1,000,000).
If a corporation has preferred stock outstanding, the relevant name is return on common equity and will be calculated as follows: net income after tax minus the required dividends on its preferred stock, divided by the average amount of common stockholders' equity during the period of the income.
As with most ratios, you should compare your corporation's return on equity with the ratio for other corporations in your industry.
Studies show that exam questions are a great way to learn and retain important information. Gain access to our 1,700 accounting exam questions (and answers) when you upgrade to PRO.