Last week, I talked about ratio analysis as a whole and the right and wrong uses for the method. This week, as I promised, I will described a few types of ratios and what they are used for.
The first is the Return on Equity. Often times when running a firm, one can ask oneself, is 30 million dollars in net income good or bad? At the exterior, it might seem like a big number and a lot of money, so it could sound like a good amount. However, if the company has billions of dollars worth of inventory, 10 million dollars is not so much of a big percentage of that inventory. This is why we use Return on Equity. ROE, short for Return on Equity, is defined as Net Income/Average Shareholder’s Equity. The ROE also measures Return on Investment, which increases with the risk of the company/firm.
There are two key factors in the Return on Equity, and they are operating performance, and financial leverage. Operating performance is how effective the managers of the company are when using the firm’s resources to generate profit, and also goes by the name of Return on Assets. Return on Assets is defined as Net Income/Average Assets. Financial leverage is how much the managers of the company use debt to increase assets for a given level of shareholder investment. Financial Leverage is defined as the equation Average Assets/Average Shareholder’s Equity.
The Return on Assets is a part of the Return on Equity ratio, but deserves its own section due to its complexity and usefulness. There are two drivers to the Return on Assets value, and they are Profitability and Efficiency. Profitability is similar to the general everyday definition of profitability, and is how much profit the company earns per each dollar of sales that it makes. This can also be called the Return on Sales, which is defined by the equation Net Income/Sales. Efficiency is how much sales the company generates with its available resources, and it also goes by the name of Asset Turnover, defined by the equation Sales/Average Assets.
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- Why do we need benchmarks in ratio analysis?
- What are some mistakes that can be made with ratio analysis?
- If your company owns 2 billion dollars worth of laptop inventory and your net income is 400 million dollars, is your company doing well or not?
- What are the different types of ratios that companies commonly use to perform ratio analysis?
- Give the equation of the ROE, ROA, ROS, Financial Leverage, and Asset Turnover.