Issue #43

Return On Equity and What $800,000 Really Earned

Happy Friday,

Welcome back to Balance Sheet. Every issue follows one real business with a problem hiding in its numbers, walks through what went wrong on the books, and shows you the fix.

Today's issue is about return on equity, the measure that shows what each dollar of ownership actually earns. Natalie Okafor runs a dog daycare and boarding business in Madison, Wisconsin, and $800,000 of her equity was producing $56,000 a year, a 7% return. A low-cost stock index fund has historically averaged around 10% a year, with no 6 a.m. kennel duty. The fix was a DuPont analysis that showed exactly which part of the business was dragging the return down.

Let's check what went wrong and what it can teach you before you put another dollar into your business.

The question at the annual review

Tailwind Dog Lodge has 60 daycare spots, 24 boarding suites, and a waitlist every holiday weekend. Natalie opened it in 2017 and bought the building in 2020. In 2025, revenue reached $1.12 million, and the business has never posted a loss.

At her annual review in January, her financial planner, Greg Haldane, asked one question. If someone handed Natalie $800,000 in cash today, would she use it to buy Tailwind?

She said yes without thinking. Greg showed her the math.

The formula

Return on equity (ROE) measures how much net income the business generates for every dollar of owners' equity.

ROE = Net income ÷ Average owners' equity

Equity is total assets minus total liabilities. For a small business, that's the money the owners put in plus every dollar of profit they left in. Use the average of beginning and ending equity, because net income is earned across the whole year and the balance sheet only captures one day.

Line item	Amount
Net income	$56,000
Beginning equity	$776,000
Ending equity	$824,000
Average equity	$800,000

ROE = $56,000 ÷ $800,000 = 7.0%

ROE is how you compare a business to every other place your money could go. Natalie's equity could sit in Treasury bills, an index fund, a rental property, or Tailwind. A single small business carries far more risk than a diversified fund, so it should earn noticeably more to justify the work and the risk. Tailwind was earning less.

Breaking the number apart

A low ROE tells you something is wrong. The DuPont formula tells you where.

ROE = Net profit margin × Asset turnover × Equity multiplier

Each piece answers a different question.

Net profit margin = Net income ÷ Revenue Asset turnover = Revenue ÷ Average total assets Equity multiplier = Average total assets ÷ Average equity

Tailwind averaged $900,000 in total assets during 2025.

Component	Tailwind	What it measures
Net profit margin	5.0%	Profit kept from each sales dollar
Asset turnover	1.24x	Sales produced by each dollar of assets
Equity multiplier	1.13x	How much the business relies on debt
Return on equity	7.0%	Profit earned on the owners' money

The 5% margin was thin, but in line with what Natalie expected for a labor-heavy service business. The other two numbers told the real story.

Where the return was leaking

Greg went straight to the balance sheet. Tailwind held $450,000 in a business savings account. Natalie had been building it for years as a safety net, and it had quietly become the largest asset on the books.

This cash earned a little interest, but it counted in full as an asset and as equity. It made the denominator bigger without producing a single extra day of boarding. That's why asset turnover sat at 1.24x.

The equity multiplier explained the rest. Tailwind owned its building outright and carried almost no debt, so nearly every asset was funded by Natalie's own money.

But there’s the uncomfortable part about ROE. Borrowing raises it. Debt funds assets without adding equity, so the same profit gets divided by a smaller number. Tuesday's greenhouse story showed the other side of that trade, when the debt payments started squeezing interest coverage.

Natalie had no interest in putting a mortgage on a paid-off building just to improve a ratio. Greg agreed. Low leverage was a choice that let her sleep at night, and it was worth some return. The idle cash was different. It was costing her money and buying her almost no extra safety.

What Natalie changed

She and Greg agreed that a $200,000 reserve, a little over two months of operating expenses, was enough.

She took a $250,000 owner distribution. The money went into her personal brokerage account, where it earns market returns directly.
She converted an unused storage room into a two-table grooming station, adding about $80,000 a year in higher-margin revenue.
She raised holiday boarding rates by 8%, the first increase in three years.

Line item	2025 actual	2026 projected
Revenue	$1,120,000	$1,200,000
Net income	$56,000	$66,000
Average total assets	$900,000	$650,000
Average equity	$800,000	$550,000
Return on equity	7.0%	12.0%

Some of that jump comes from a smaller denominator, and that deserves a straight answer. Shrinking equity is one of the easiest ways to make ROE look better. It holds up here because the $250,000 kept earning in Natalie's own account, and the grooming station lifted actual profit by $10,000.

Three things to watch

A very high ROE needs a closer look. It can come from heavy debt, from years of losses that shrank equity, or from large owner distributions. Check the equity multiplier before you celebrate.

It also helps to run return on assets (ROA) alongside ROE. ROA divides net income by total assets, so it ignores how those assets were financed. When ROE is high and ROA is low, debt is doing most of the work. Tailwind's 2025 ROA was 6.2%, very close to its ROE, which confirms how little leverage the business used.

Negative equity or a net loss makes ROE meaningless. Look at the underlying numbers directly.

And compare within your industry. A dog boarding business, a software company, and a utility will never produce similar ROEs, so benchmark against businesses that look like yours, and watch your own trend year over year.

Back to Tailwind

Greg asked Natalie the same question at the end of the meeting. Would she buy Tailwind with $800,000? This time she had a real answer: not at 7%, and yes at 12%.

That wraps up a four-issue run on the numbers lenders and investors check first: days sales outstanding, free cash flow, interest coverage, and return on equity. Each one starts with a few lines from your financial statements and ends with a better decision.

Balance Sheet
The numbers behind every smart business decision.
Published every Monday and Friday.