Why use ratios?
It has been said that you must measure what you expect to manage and accomplish. Without measurement, you have no reference to work with and thus, you tend to operate in the dark. One way of establishing references and managing the financial affairs of an organization is to use ratios. Ratios are simply relationships between two financial balances or financial calculations. These relationships establish our references so we can understand how well we are performing financially. Ratios also extend our traditional way of measuring financial performance; i.e. relying on financial statements. By applying ratios to a set of financial statements, we can better understand financial performance.
Calculating Return on Equity
For publicly traded companies, the relationship of earnings to equity or Return on Equity is of prime importance since management must provide a return for the money invested by shareholders. Return on Equity is a measure of how well management has used the capital invested by shareholders. Return on Equity tells us the percent returned for each dollar (or other monetary unit) invested by shareholders. Return on Equity is calculated by dividing Net Income by Average Shareholders Equity (including Retained Earnings).
Net Income for the year was € 80,000, total shareholder equity at the beginning of the year was $ 225,000 and ending shareholder equity for the year was € 275,000.
Return on Equity is calculated by dividing € 80,000 by € 250,000 (average shareholders equity which is € 225,000 + € 275,000 / 2). This gives us a Return on Equity of 32%.
For each Euro invested by shareholder 32% was returned in the form of earnings i.e. for every €1 invested by shareholders, €0.32 was generated in net income. This is a strong indicator of the company’s ability to generate profits from shareholders’ equity.
Return on Equity is one of the most widely used ratios for publicly traded companies. It measures how much return management was able to generate for the shareholders. The formula for calculating Return on Equity is: Net Income / Average Shareholders Equity
Components of Return on Equity
Return on Equity has three ratio components.
1. Profit Margin = Net Income / Sales
2. Asset Turnover = Sales / Assets
3. Financial Leverage = Assets / Equity
Profit Margin measures the percent of profits you generate for each dollar of sales. Profit Margin reflects your ability to control costs and make a return on your sales. Profit Margin is calculated by dividing Net Income by Sales. Management is interested in having high profit margins.
Net Income for the year was € 80,000 and Sales were € 640.000. Profit Margin is € 80,000 / € 640,000 or 12,5%. For each dollar of sales, we generated € 0,125 of profits.
Asset Turnover measures the percent of sales you are able to generate from your assets. Asset Turnover reflects the level of capital we have tied-up in assets and how much sales we can squeeze out of our assets. Asset Turnover is calculated by dividing Sales by Average Assets. A high asset turnover rate implies that we can generate strong sales from a relatively low level of capital. Low turnover would imply a very capital-intensive organization.
Sales for the year were € 640,000, beginning total assets was € 605,000 and year-end total assets are € 595,000. The Asset Turnover Rate is € 640,000 / € 600,000 (average total assets which is € 605,000 + € 595,000 / 2) or 0.60%. For every €1.00 of assets, the company was able to generate € 1.067 of sales.
Financial Leverage is the third and final component of Return on Equity. Financial Leverage is a measure of how much we use equity and debt to finance our assets. As debt increases, we financial leverage increases. Generally, management tends to prefer equity financing over debt since it carries less risk. The Financial Leverage Ratio is calculated by dividing Assets by Shareholder Equity.
Average assets are € 600,000 and average shareholder equity is € 400,000. Financial Leverage Ratio is € 600,000 / € 400,000 or 1.5. For each € 1.5 in assets, we are using €1.00 in equity financing.”
Now let us compare our Return on Equity to a combination of the three component ratios:
From our example, Return on Equity = € 40,000 / € 340,000 or 11.76% or we can combine the three components of Return on Equity from our examples:
Profit Margin x Asset Turnover x Financial Leverage = Return on Equity
= 0.125 x 1.067 x 1.5 = 0.2001 or 20.01%
In one of our next blogs we will show easy to understand examples for the following detail ratios:
Liquidity, Asset Management, Profitability and Leverage. We will also look at market value ratios.