Return on Equity (RoE) is the income generated per unit of equity invested, i.e. how much returns shareholders/investors are getting on the money invested by them in the company.
It is defined as net profit divided by the average common equity for the most recent financial year. The ratio helps understand the number of units of profit generated per unit of money invested in the company. Higher the ROE better the utilisation of shareholders money.
Common equity refers to the money invested in the company by common shareholders. It is important to ensure that money invested during the financial year does not distort the ROE number. Hence average common equity, i.e average of common equity at the beginning and end of the financial year is considered for calculation.
The current year's ROE number needs to be compared with the historical ROE numbers of the company to understand whether it is efficiently utilising capital. If the ROE numbers are trending up, it is a positive sign.
ROE numbers of different companies operating in the same sector can also be compared with each other.
Learn more about ROE in our learn portal here.