Two Measures of Financial Return

Recently I’ve been focusing on financial ratios and how they can help you measure performance. You’ve probably heard the old advice on a personal level, “If you’re not using something, maybe you need to get rid of it.” Another way to look at this is whether the benefits you derive outweigh the cost of ownership or produce a positive result. An example would be stocks you own. Are they producing a reasonable return for your investment, or would your money be better off somewhere else? When it comes to business there are several ways to assess whether your returns justify your investment.

Now let’s look at some ways to measure financial return.

Return on Assets

Above I mentioned stocks you may personally own and how you need to evaluate on a regular basis whether they are providing an adequate return. Just as your personal stocks are a personal asset that should produce a return, your business should get an adequate return on its assets. The calculation for return on assets (abbreviated as ROA) is:

Return on Assets = Net Income / Total Assets

It is expressed as a percentage. It represents how efficiently management is utilizing assets. Consider the following Balance Sheet and Income Statement:

ROA calculation

In the example above the return on assets is calculated as:

ROA = Net Income / Total Assets = $450,000 / $3,100,000 = 14.5%

In the personal realm we would feel pretty good if we were averaging 14.5% return on any assets we owned. With a business, however, whether the return on assets is good depends on such things as the particular business, where it is in the growth cycle, and the industry it belongs to. This also is a reflection of balance sheet management, particularly asset management.

Return on Equity

The calculation of return on equity (abbreviated as ROE) is a measure of the return on stockholders’ investment in a business. It is calculated as follows:

ROE = Net Income / Total Equity

In the example above it is calculated as follows:

ROE = Net Income / Total Equity = $450,000 / $1,655,000 = 27.2%

Again, whether this is a good return depends on such things as the particular business, where it is in the growth cycle, and the industry it belongs to. Once this is understood, the return on equity is a useful measure of the value stockholders are getting for their investment in the company.

Like all financial measurement, there is generally more to these than just a raw number. While at some point in your business’s life cycle a 10% ROA or a 5% ROE may be fine, at another time these same returns may be woefully inadequate.

The point is, do you know what returns you are receiving? If not, perhaps a Part-time CFO or Controller could be of benefit.

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.

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