Many companies use external funds to pay for business projects or other major operations. One form of external investment is equity funds from investors. Common equity represents all money invested into a company’s common shares of stock. The return on common equity is a measurement of profitability based on dividing net income by common equity. The formula deducts preferred share dollar amounts from both net income and common equity to compute the figure properly.
Publicly held companies are often the businesses that use the return of common equity most often. This measurement provides both internal and external stakeholders with information on how well the company makes money from these funds. The percentage of return indicates the efficiency and effectiveness of the company’s use of funds. Shareholders are often most interested in this return because it represents money the company can return to them in the form of dividends or other benefits. Companies can compute the return on common equity whenever it has available financial statements.
Net income and common equity are the two basic pieces for computing the return on common equity. A company’s net income is on the income statement, and common equity is on the balance sheet. The other figure needed is preferred shares, which is also on the balance sheet. Accountants or financial analysts need to subtract the figure for preferred shares from both net income and common equity. Then, dividing the difference for net income by the difference from common equity will result in the return on common equity.
In most casts, a higher figure from this formula indicates that a company is fairly effective and efficient when using money from common equity. Therefore, a lower percentage indicates less money earned from the use of shareholder funds. A company may also need to benchmark its return on common equity in order to determine how well it compares to similar companies. Investors can also compute this information on their own. This is possible because publicly held companies usually have requirements to release financial information for public use.
The return on common equity formula is not an entirely useful process for measuring a company’s profitability or efficiency. The formula only measures one piece of a company’s financial process. Common equity measurements and measuring the effective use of debt are similar tools. These together can provide a better look at a company’s overall efficiency in terms of use for external funds.