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Management Effectiveness ratios are a measure of how effectively management is managing the business. Their job is to make important decisions, about how to invest the company’s money.
In a small business, the owner may be the whole management team. In that case, we want to see how well the business resources are being managed.
Two metrics we look at here are Return on Assets, and Return on Equity.
Return on Assets gives us an idea of how well the company’s money is being invested. If we purchase major equipment (fixed assets), is that investment producing a return? We compare net income with the total assets, as a benchmark to see if the company’s funds are being invested well.
What Does Return On Assets – ROA Mean?
An indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company’s annual earnings by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as “return on investment”.
Note: Some investors add interest expense back into net income when performing this calculation because they’d like to use operating returns before cost of borrowing.
ROA tells you what earnings were generated from invested capital (assets). ROA for public companies can vary substantially and will be highly dependent on the industry. This is why when using ROA as a comparative measure, it is best to compare it against a company’s previous ROA numbers or the ROA of a similar company.
The assets of the company are comprised of both debt and equity. Both of these types of financing are used to fund the operations of the company. The ROA figure gives investors an idea of how effectively the company is converting the money it has to invest into net income. The higher the ROA number, the better, because the company is earning more money on less investment. For example, if one company has a net income of $1 million and total assets of $5 million, its ROA is 20%; however, if another company earns the same amount but has total assets of $10 million, it has an ROA of 10%. Based on this example, the first company is better at converting its investment into profit. When you really think about it, management’s most important job is to make wise choices in allocating its resources. Anybody can make a profit by throwing a ton of money at a problem, but very few managers excel at making large profits with little investment.
Return on Equity gives us an idea of how well the investment is performing, for anyone who has invested in the company. Again, that may be the business owner him or herself. We still want to know if their investment is producing a good return. We look at net income compared with total equity to get a measure of how well the investor’s investment in the business is performing.
What Does Return On Equity – ROE Mean?
The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested.
The ROE is useful for comparing the profitability of a company to that of other firms in the same industry.
There are several variations on the formula that investors may use:
1. Investors wishing to see the return on common equity may modify the formula above by subtracting preferred dividends from net income and subtracting preferred equity from shareholders’ equity, giving the following: return on common equity (ROCE) = net income – preferred dividends / common equity.
2. Return on equity may also be calculated by dividing net income by average shareholders’ equity. Average shareholders’ equity is calculated by adding the shareholders’ equity at the beginning of a period to the shareholders’ equity at period’s end and dividing the result by two.
3. Investors may also calculate the change in ROE for a period by first using the shareholders’ equity figure from the beginning of a period as a denominator to determine the beginning ROE. Then, the end-of-period shareholders’ equity can be used as the denominator to determine the ending ROE. Calculating both beginning and ending ROEs allows an investor to determine the change in profitability over the period.