Return on … Ratios
There are several ratios that are calculated by dividing the Net Income by another financial measure. These ratios are often used to compare the efficiency of one company with another.
When to Use Return on … Ratios
Return ratios are normally used for comparing companies or comparing the past performance of a company with its present performance. They provide a quick evaluation of the company efficiency.
- Return ratios are calculated by dividing the Net Income by another financial attribute.
- The Return on Sales (ROS) is a popular ratio. It shows how well the business is able to turn the activity of its current operations into profit.
- It divides Net Income for a period by the total sales for that same period.
- ROS can be increased by raising Net Income faster than an increase in sales. This is normally achieved by cutting costs somewhere in the operations without the cost cutting impacting current sales.
- It is easy to raise ROS by stopping all investment activity. This gives short term benefit but hurts the business in the long term.
- The Return on Assets (ROA) is a business efficiency ratio. It shows how well a company is able to use its asset base to create net income. It is often used with companies that have a high level of capital or fixed assets.
- The ROA is calculated by dividing the Net Income for a time period by the average total assets during that time period. The average total assets are the average value for assets from the Balance Sheet at the beginning and the end of the time period.
- ROA can be increased by increasing the Net Income through increased sales or lower cost or by lowering the asset base through the sale or disposal of assets.
- ROA must be used carefully and the business operation must be well understood. For instance, a company that uses contract manufacturing will often have a much higher ROA than one with its own factories since the company with contract manufacturing has fewer fixed assets. However, the risk profile between companies is not the same, even though they are in the same industry.
- The Return on Equity (ROE) is a business efficiency ratio. It shows how well the company is returning value to investors. It is often used with companies that do not pay dividends.
- The ROE is calculated by dividing the Net Income for time period by the average equity during that same period. The average equity is the average of the value of the equity at the start and end of the time period.
- ROE can be increased by increasing assets without increasing liabilities, decreasing liabilities without decreasing assets, or increasing Net Income without impacting assets and liabilities.
- ROE is a good measure for the investment community. When a company is going through major structural change because of acquisition or divestiture, watch the ROE closely to understand the impact of the changes.
Hints and Tips
- Don’t fixate on one ratio. A clever management team can manipulate that business so that one ratio looks good, but the business must be well run for all the ratios to look good.
- During times of business structural transition, watch closely what is happening on the balance sheet, the changes in assets, liability and equity can have a huge impact on ROA and ROE.
- Watch the trends of each of these ratios. A sudden shift is often caused by a structural change. A negative trend is an indication of management not adapting to the industry and market realities.
- The definition of a “high” or “low” ratio will vary significantly by industry.
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