All return on capital metrics help us to assess the level of earnings generated by a defined amount of capital. An important metric for measuring returns, particularly for shareholders is return on equity. This metric is really asking the question, how much profit is the company generating for each Dollar of equity invested in the company? Now, return on equity is calculated by dividing the earnings generated for shareholders, that's net income, by the book value of equity in the balance sheet. But what do we mean by book value of equity? Well, in practice, there are two slightly different ways of determining this. The first way is to identify the book value of equity at the start of the year. When we use this in our return calculation, we sometimes refer to this as return on opening equity. The second way is to calculate the average of opening and closing equity. When we use this in our return calculation, we refer to it as return on average equity. Now, both of these methods are valid ways of calculating return on equity as long as the same method is being applied consistently throughout our analysis and forecasts.

Whenever we use return measures, we need to ensure consistency between our numerator and our denominator. Note how we're using net income and equity in our calculation. It wouldn't make sense to use operating profit as our earnings measure and equity in the denominator as this means we have inconsistency between the numerator and denominator. Operating profit can be used to pay interest to debt investors as well as dividends to equity investors by using net income, which is generated only for shareholders. We ensure that we have consistency in our return measure. However, one item of note when analyzing return on equity is that it can be distorted by leverage differences. Net income is after interest expense, so if a company has much higher or lower leverage than peer companies, it can distort return on equity.