ROE in One Line
Return on equity, or ROE, measures how much profit after tax a company earns for every pound the shareholders have in it.
ROE = profit after tax ÷ shareholders' equity × 100
If a company makes £46,000 after corporation tax and its shareholders' equity is £182,000, its ROE is 46,000 ÷ 182,000, which is 25.3%. Each £1 belonging to the owners earned about 25p in the year.
ROE is the shareholder's version of return on capital employed. ROCE looks at all the long-term money in a business, from owners and lenders alike. ROE looks only at the owners' slice, and only at the profit left once lenders and HMRC have been paid.
The Two Parts of the Formula
Profit after tax
The top line is profit for the year after interest and corporation tax. It is the bottom line of the profit and loss account, the figure that belongs to shareholders. We explain how it differs from gross and operating profit in gross profit vs net profit.
Dividends are not deducted. They are paid out of this profit, not as a cost in arriving at it. If the company has preference shares, take off the preference dividend first, because ROE is a measure for ordinary shareholders. Very few owner-managed companies have preference shares, but exam questions love them.
Shareholders' equity
Equity is the bottom section of the balance sheet, usually labelled "capital and reserves". It is mostly share capital plus retained earnings, and it always equals total assets minus total liabilities. That is the accounting equation at work.
In a typical UK owner-managed company the share capital is £100 or even £1, so equity is almost entirely retained profit that has not yet been paid out as dividends. Keep that in mind, because it explains most of what makes small company ROE behave oddly.
A Worked Example
Brookfield Joinery Ltd makes bespoke kitchens and staircases in Enfield. It has a 31 March year end and one director-shareholder.
For the year to 31 March 2026:
| Item | Amount |
|---|---|
| Turnover | £540,000 |
| Profit before tax | £57,500 |
| Corporation tax (with marginal relief) | £11,500 |
| Profit after tax | £46,000 |
| Dividends paid to the director | £32,000 |
| Equity at 1 April 2025 | £168,000 |
| Equity at 31 March 2026 | £182,000 |
| Total assets at 31 March 2026 | £360,000 |
Equity grew by £14,000, which is the £46,000 profit less the £32,000 of dividends.
ROE = 46,000 ÷ 182,000 × 100 = 25.3%
Year-end or average equity?
The profit was earned across the whole year, but year-end equity is a single day's figure. Many analysts, and some exam questions, use average equity instead:
Average equity = (168,000 + 182,000) ÷ 2 = £175,000
ROE on average equity = 46,000 ÷ 175,000 = 26.3%
For a stable company the two versions are close. For a company that raised new share capital, paid a large dividend or made a loss during the year, they can be miles apart. If you are tracking your own business, pick one and stick to it. If you are answering an exam question, use year-end equity unless you are given opening figures or told otherwise.
The DuPont Breakdown
ROE on its own tells you the result but not the reason. The DuPont method, named after the US chemicals company that used it in the 1920s, splits ROE into three ratios multiplied together:
ROE = net profit margin × asset turnover × equity multiplier
For Brookfield:
- Net profit margin = 46,000 ÷ 540,000 = 8.52%
- Asset turnover = 540,000 ÷ 360,000 = 1.50 times
- Equity multiplier = 360,000 ÷ 182,000 = 1.98 times
8.52% × 1.50 × 1.98 = 25.3%.
Each part points at a different lever:
- Margin is about pricing and cost control. Are you keeping enough of each sale?
- Asset turnover is about efficiency. Are the workshop, machinery, stock and debtors producing enough sales? Our guide to stock turnover covers one big piece of this.
- The equity multiplier is about borrowing. The more of the assets funded by lenders and creditors, the higher the multiplier, and the higher ROE goes for the same trading performance. This is the gearing ratio in disguise.
We find DuPont the most useful thing to show a director when ROE has moved. "ROE fell from 31% to 25%" starts an argument. "Margin held, but asset turnover fell because debtors went from 38 to 61 days" starts a plan.
What Is a Good ROE?
The rule of thumb on most investment sites is that an ROE of 15% to 20% or more is good. That is a reasonable starting point, but for a private company we would test it against two things.
What else the money could earn. With Bank Rate at 3.75% in September 2026, a company deposit account pays somewhere in the region of 3% to 4% with no risk at all. A trading company carries real risk: bad debts, a lost contract, a key person falling ill. If its ROE is 6%, the shareholders are taking a lot of risk for very little extra return. We would want to see at least two or three times the risk-free rate before calling a small company's ROE healthy.
What the owner actually takes home. ROE is measured inside the company, after corporation tax but before personal tax. If Brookfield's director is a higher rate taxpayer and took the full £46,000 as dividends, they would pay dividend tax at 35.75% on most of it, keeping around £29,500. On £182,000 of equity, that is roughly 16% in the owner's pocket. Still a good return, but not the 25% the headline suggests. The dividend tax calculator will show you the figure for your own income.
Sector matters too. Asset-heavy businesses such as manufacturing, haulage and property tend to have lower ROE than service firms that need little more than people and laptops. Compare yourself with similar businesses and with your own last three to five years, not with a number you read on a share-tipping site.
Why Small Company ROE Is So Easy to Distort
This is where owner-managed companies part company with the textbook. The formula is the same, but the way small companies hold and extract money changes the answer dramatically.
1. Dividend policy moves the bottom of the formula
Equity in a small company is mostly profit that has not been paid out. Pay more out and equity shrinks, so ROE rises. Leave it in and equity grows, so ROE falls.
If Brookfield's director had taken all £46,000 as dividends, closing equity would be £168,000 and ROE would be 27.4%. If they had taken nothing, closing equity would be £214,000 and ROE would be 21.5%. Same business, same profit, same year, and ROE ranges over six percentage points purely because of what the director decided to draw.
That is why we never read a falling ROE in an owner-managed company as bad news until we have checked the dividends. Often it just means the owner has stopped extracting, perhaps because they are already in the higher rate band.
2. Surplus cash drags ROE down
Plenty of profitable small companies sit on large cash balances, because taking the money out costs personal tax. All that cash is part of equity.
Brookfield has £95,000 in the bank, of which we would say about £70,000 is surplus to its working needs. At around 3.5% that earns £2,450 of interest, roughly £1,800 after tax. Take the surplus cash and the interest it earns out of the calculation and you get the return on the joinery business itself:
Trading ROE = (46,000 − 1,800) ÷ (182,000 − 70,000) = 44,200 ÷ 112,000 = 39.5%
That 39.5% is the number that tells the director how good the business is. The 25.3% headline mixes a very good joinery business with a cash pile earning deposit rates. Separating the two is often the starting point for a conversation about what to do with the cash: invest it in the business, pay it out over several tax years, put it into a pension, or keep it as a buffer on purpose.
3. Borrowing can push ROE up with nothing improving
Suppose that on 1 April 2025 Brookfield had borrowed £80,000 at 7.5% and paid it straight out as an extra dividend. Nothing about the joinery changes. But:
- Interest of £6,000 reduces profit before tax to £51,500
- Corporation tax falls to about £9,900, leaving profit after tax of about £41,600
- Closing equity falls to about £97,600
ROE rises from 25.3% to about 42.6%.
The business is no better run. It is just carrying more debt and more risk. If trading has a bad year, the interest still has to be paid. This is why we think ROE is a poor basis for management bonuses on its own, and why lenders look at gearing and interest cover alongside it. ROCE is much harder to inflate this way, because it includes the borrowed money in the bottom half of the formula.
There is a legal limit here too. A company can only pay dividends out of distributable profits under section 830 of the Companies Act 2006. Borrowing to fund a dividend does not create distributable profits, so it only works if the retained earnings are already there.
4. Tiny or negative equity makes ROE meaningless
A company that has paid out almost everything it has ever earned may have equity of a few thousand pounds. A £40,000 profit on £5,000 of equity is an ROE of 800%. That is not a sign of a brilliant business, just a small denominator.
The opposite case is worse. A young company with accumulated losses has negative equity. A profit divided by negative equity gives a negative ROE, which looks like a loss when the company has actually turned the corner. When equity is negative or very small, ignore ROE and look at margins, cash flow and the current ratio instead.
5. The director's loan account is often equity in all but name
Many directors put money into their company as a loan rather than share capital. It sits in creditors, not equity. If the director has no intention of taking it out, it behaves exactly like equity, and banks often treat it that way if it is formally subordinated.
If Brookfield's director had lent the company £40,000, the true return on the owner's money would be calculated on £222,000, not £182,000. We look at the director's loan account before quoting an ROE for any owner-managed company.
6. The director's pay
Like ROCE, ROE is flattered when the director takes a small salary and the rest as dividends, because dividends are not a cost. We cover this adjustment in detail in our ROCE guide and in directors' remuneration. If you are using ROE to judge whether the business is worth what a buyer is offering, replace the director's salary with what it would cost to hire someone to do their job.
ROE vs ROCE vs ROA
| Ratio | Formula | Who it is for |
|---|---|---|
| ROE | Profit after tax ÷ shareholders' equity | Shareholders: what is my money earning? |
| ROCE | Operating profit ÷ capital employed | Owners and lenders together: how well is all the long-term funding used? |
| ROA | Profit after tax ÷ total assets | Anyone comparing how hard the assets are working, regardless of funding |
For Brookfield, ROA is 46,000 ÷ 360,000, which is 12.8%. ROE is higher than ROA whenever the company uses any liabilities to fund its assets, and the gap between them is the equity multiplier from the DuPont breakdown.
Our view: ROE is the right question for a shareholder deciding whether to keep money in a company. ROCE is the better question for judging how well the business is run. Use both, and if ROE is rising while ROCE is flat or falling, the improvement is coming from debt rather than trading.
Common Mistakes
- Using operating profit or profit before tax. ROE uses profit after tax. Profit before interest belongs to the ROCE formula.
- Deducting dividends from profit. Dividends are a distribution of profit, not a cost. Use the profit for the year before dividends.
- Including the director's loan or bank loans in equity in an exam answer. In real life you might adjust for a long-term director's loan, but the standard formula uses capital and reserves only.
- Comparing year-end ROE with average-equity ROE. Check the version before comparing with a benchmark.
- Reading ROE when equity is tiny or negative. The answer will be huge or negative and tells you nothing.
- Ignoring personal tax. For an owner-managed company, the return you actually receive is lower once dividend tax is paid.
How IAK Can Help
We work with limited companies, small businesses and construction companies across North London and Hertfordshire. ROE usually comes up when an owner is deciding whether to keep cash in the company, take on borrowing, bring in an investor, or sell.
The calculation is easy. The judgement is in separating the trading business from the cash it is sitting on, and seeing how much of the return is down to dividend policy or debt rather than the work itself. That is where an accountant who knows the business earns their fee.
If you want ROE and the other key ratios tracked through the year, see our management reporting service. For year-end accounts that a buyer, investor or lender will read, see our accounting service, or get in touch to talk it through.
Sources
- Corporation Tax rates and reliefs, GOV.UK, for the 25% main rate, the 19% small profits rate and marginal relief used in the worked example.
- Tax on dividends, GOV.UK, for dividend tax rates and the £500 dividend allowance.
- Bank Rate maintained at 3.75%, September 2026 Monetary Policy Summary, Bank of England, for Bank Rate at 3.75% in September 2026.
- Companies Act 2006, Part 23, legislation.gov.uk, for the rule in section 830 that dividends may only be paid out of profits available for distribution.
- Financial statement analysis and interpretation, OpenLearn, The Open University, for the standard definitions of return ratios used in UK financial statement analysis.