RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-

RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-

ings or net income, with measures of investment. For example, if you want to evaluate how well the firm uses its assets in its operations, you could calculate the return on assets—sometimes called the basic earning power ratio—as the ratio of earnings before interest and taxes (EBIT) (also known as operating earnings) to total assets:

Earnings before interest and taxes

Basic earning power = ---------------------------------------------------------------------------------------

Total assets For Fictitious Corporation, for 1999:

Basic earning power = 0.1818 or 18.18%

= ---------------------------------

For every dollar invested in assets, Fictitious earned about 18 cents in 1999. This measure deals with earnings from operations; it does not consider how these operations are financed.

Another return-on-assets ratio uses net income—operating earnings less interest and taxes—instead of earnings before interest and taxes: 1

1 In actual application the same term, return on assets, is often used to describe both ratios. It is only in the actual context or through an examination of the numbers

themselves that we know which return ratio is presented. We use two different terms to describe these two return-on-asset ratios in this chapter simply to avoid any con- fusion.

FINANCIAL STATEMENT ANALYSIS

Net income

Return on assets = ------------------------------

Total assets For Fictitious in 1999:

$1,200,000 Return on assets = --------------------------------- = 0.1091 or 10.91% $11,000,000

Thus, without taking into consideration how assets are financed, the return on assets for Fictitious is 18%. Taking into consideration how assets are financed, the return on assets is 11%. The difference is due to Fictitious financing part of its total assets with debt, incurring interest of $400,000 in 1999; hence, the return-on-assets ratio excludes 1999 taxes of $400,000 from earnings in the numerator.

If we look at Fictitious’ liabilities and equities, we see that the assets are financed in part by liabilities ($1 million short term, $4 million long term) and in part by equity ($800,000 preferred stock, $5.2 million common stock). If we look at the information as investors, we may not

be interested in the return the firm gets from its total investment (debt plus equity), but rather shareholders are interested in the return the firm can generate on their investment. The return on equity is the ratio of the net income shareholders receive to their equity in the stock:

Net income

Return on equity = -----------------------------------------------------------------------------------------

Book value of shareholders’ equity For Fictitious Corporation, there is only one type of shareholder:

common. For 1999:

$1,200,000 Return on equity = ------------------------------ = 0.2000 or 20.00% $6,000,000

Recap: Return-on-Investment Ratios The return-on-investment ratios for Fictitious Corporation for 1999 are:

Basic earning power = 18.18% Return on assets

Return on equity

These return-on-investment ratios tell us:

Financial Ratio Analysis

■ Fictitious earns over 18% from operations, or about 11% overall, from its assets. ■ Shareholders earn 20% from their investment (measured in book value terms).

These ratios do not tell us: ■ Whether this return is due to the profit margins (that is, due to costs

and revenues) or to how effectively Fictitious uses its assets. ■ The return shareholders earn on their actual investment in the firm, that is, what shareholders earn relative to their actual investment, not the book value of their investment. For example, you may invest $100 in the stock, but its value according to the balance sheet may be greater than or, more likely, less than $100.