Return on Owner's Equity

Return on owner's equity is one of the most important measures of an organization's profitability. It allows observers to measure the rate of return of an owner's investment. Observers use the information to discover trends through comparison of current and prior periods and to determine competitiveness through comparison with industry peers. The standard calculation for return on owner's equity (ROE) is expressed as a percentage and is computed using the following formula:

Net earnings, also known as the net income of the organization, is the profit or loss after consideration of all revenues and expenses recognized during an accounting period. The term net earnings is also used to refer to the accrued profit available for distribution to the stockholders or owners. Stockholder's equity is equal to all assets minus all liabilities. Often referred to as common equity, stockholder's equity is composed of common stock and retained earnings. For not-for-profit organizations, including many hospitals, stock-holder's equity is referred to as fund balance or net assets.

ROE is often used with return on assets (ROA), defined as net income to total assets, to measure the overall efficiency of an organization's management. ROE is significantly different from ROA, however, in that ROE addresses the organization's debt leveraging. Thus ROE—unlike ROA—can provide an observer with information on how the organization's management team uses the tools of profitability, asset management, and financial leverage to influence an organization.2 The DuPont analysis provides an alternative method for calculating ROE that allows observers to determine the impact of the decisions and the activities of the organization's management by examining the trend of the measurements found in the DuPont analysis.

The DuPont analysis calculates ROE using the following method:3

The profit margin measurement shows the impact of raising and lowering charges. Charging for a procedure to remain profitable while also sustaining patient volume is challenging and vital to creating profits. The impact of new service lines or markets and contracts with managed care organizations are seen in the measure of profit margin. [Page 490]Total asset turnover measures an organization's ability to manage its assets. By generating more revenue with fewer assets, an organization can decrease expenses required to maintain capital equipment and can return the increased gains from operations to its owners. Finally, financial leverage measures the organization's use of debt to support operations. Debt can be used to add capacity to an operation that ultimately increases earnings by greatly increasing volumes at a slightly lower profit margin, which leads to an increase in ROE. The danger is that too much debt eventually erodes profit margins through increased interest costs and decreases asset turnover, thus decreasing ROE. Therefore, ROE allows an observer to determine if the organization's management is properly managing profits, assets, and debt to the benefit of the organization's owners.